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The problem of how to account for asset securitization transactions
Journal of Accounting Education, Vol. 15, No. 1, pp. 39 51, 1997
© 1997 ElsevierScience Ltd All rights reserved. Printed in Great Britain 0748-5751/97 $17.00 + 0.00
Pergamon
PII: S0748-5751(96)00039-5
THE
PROBLEM
OF
HOW
TO
SECURITIZATION
ACCOUNT
FOR
ASSET
TRANSACTIONS
Gregory D. Kane UNIVERSITY O F D E L A W A R E Abstract: Asset securitization is a sophisticated new financial tool that has enabled increasing
numbers of firms to liquefy their balance sheets and find alternative sources of investment capital. The purpose of this paper is to highlight some of the fundamental accounting problems associated with asset securitization. A simple case is presented that can be used as a basis for discussions about how to account for asset securitization transactions. A description of asset securitization, as well as current and prospective treatment alternatives, is also provided. © 1997 Elsevier Science Ltd
INTRODUCTION A s s e t securitization is a s o p h i s t i c a t e d new financial tool t h a t has e n a b l e d increasing n u m b e r s o f firms to liquefy their b a l a n c e sheets a n d find a l t e r n a t i v e sources o f i n v e s t m e n t capital. T o d a y h u n d r e d s o f firms engage in s e c u r i t i z a t i o n t r a n s a c t i o n s . A s a result, yearly new issues o f a s s e t - b a c k e d securities have e x p o n e n t i a l l y increased f r o m j u s t 1.237 billion in 1985 to o v e r 130 billion by 1993 ( J a b l a n s k y , 1993). A whole range o f assets can n o w be securitized, including leases, credit c a r d receivables, c a r loans, a n d c o m m e r c i a l loans. S e c u r i t i z a t i o n t r a n s a c t i o n s raise a n u m b e r o f intriguing c o n c e p t u a l q u e s t i o n s c o n c e r n i n g the m e a n i n g o f sales, assets, a n d the r e p o r t i n g entity.l T h e y also b r i n g to the f o r e f r o n t a n u m b e r o f f u n d a m e n t a l issues t h a t h a v e p l a g u e d historical cost a c c o u n t i n g for a long time: i.e., t r e a t m e n t o f n o n - e x e c u t o r y contracts, c o n t i n g e n c y events, a n d how, o r whether, to m e a s u r e wealth c h a n g e s t h a t are n o t t r a n s a c t i o n - d r i v e n . A c c o u n t i n g for s e c u r i t i z a t i o n can thus be a very useful, c o m p r e h e n s i v e , t o p i c in the c l a s s r o o m , especially when case discussion a n d o t h e r m e t h o d s o f interactive teaching a r e applied. T h e topic p r o v i d e s an o p p o r t u n i t y to e n g a g e s t u d e n t s to t h i n k b e y o n d the m e c h a n i c s o f j o u r n a l entries a n d trial b a l a n c e s a n d i n s t e a d c o n s i d e r the basic c o n c e p t s a n d objectives t h a t u n d e r l i e the r e p o r t i n g process, including the extent to which c u r r e n t a n d ~A number of articles in the literature have discussed some of the conceptual problems with securitization. These include Kane (1995), Perry (1993), Imhoff (1992), and Swieringa (1989). 39
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G . D . Kane
proposed accounting methods can capture the economic substance of complex and quickly changing forms of business activity. The purpose of this paper is to highlight some of the fundamental accounting problems associated with asset securitization. A simple case is presented that can be used as a basis for discussions about how to best account for asset securitization transactions. A description of asset securitization, as well as current and proposed treatment alternatives, is also provided. BACKGROUND Asset securitization occurs when a company (hereafter, the originator firm) transfers a portfolio of assets, typically loans, to a special purpose entity (hereafter, SPE), which is usually a trust. The SPE is established by the company solely for the purpose of conducting a securitization transaction. The SPE then issues securities which may take a form similar to fixed or floating rate debt, equity, or some combination thereof The proceeds the SPE receives from the sale of securities are then transferred back to the originator firm. As loan and interest payments from the securitized loans are paid in to the SPE, the trust uses these funds to pay SPE security holders' claims. The SPE may also pay the originator firm a service fee for managing securitized loans. The transaction proceeds until all of the SPE's obligations, including security holders' claims, have been discharged. Any cash received in excess of that required to service securitized assets and pay security holder claims (hereafter, the spread) is typically accumulated by the SPE and, at the conclusion of the transaction, paid to the holder of the remainder interest, usually the originator firm. Securitization technology offers a number of important advantages. In particular, the financing obtained by the SPE is little affected, with respect to credit quality, by the credit rating of the originator firm. This is because the securities backed by securitized assets are issued by a legally separate and distinct entity (i.e., the SPE). This advantage can permit firms with low credit quality to finance new business at low cost, AAA investment grade, interest rates. In addition, securitizations can be flexibly structured to take the form of, and qualify as sales, under regulatory accounting procedures (RAP) and generally accepted accounting procedures (GAAP). As a result, off balance sheet financing can be attained through securitization, thus improving firms' leverage ratios and thereby reducing overall capitalization requirements. This has the effect of lowering the overall cost of capital while increasing the leverage potential of a given asset base. Finally, because trusts are so flexible as to structure, securitization can be used to create hybrids of equity/debt interests that are tailored to fit the needs of specific groups of investors. As with most transactions that involve the receipt of future cash flows as well as future contractual performance, a number of risks are associated
Accounting for Asset Securitization Transactions
41
with securitization transactions. These include the risk of credit default, interest rate or market risk, and prepayment risk. First, consider the risk of loan default. If transferred loans default or do not pay in timely fashion, the SPE may have insufficient funds to pay security holder claims as well as other obligations. How this risk is spread among parties to a securitization transaction is determined by the structure of a securitization transaction. To insure the highest possible credit rating, and lowest possible financing cost, the risk of credit default is often absorbed by the originator of a securitization transaction. The way this is accomplished is through the use of a variety of "credit enhancement" mechanisms including: (1) the dedication of the spread account so that it first absorbs losses from credit defaults, (2) the provision of direct recourse by the SPE back to the originator firm with respect to losses from loan defaults; (3) the holding by the originator firm of a subordinate interest in the SPE and its securitized assets; and (4) the provision of a cash collateral account and/or dedicated credit lines that can be used when SPE cash outflows temporarily exceed inflows, thus allowing for options other than immediate foreclosure of bad debt. In addition, the SPE sometimes purchases guarantees and letters of credit from third parties other than the originator firm to further protect against the risks of loan default. Second, there is interest rate, or market risk. When any loan asset has a fixed rate or return, interest rate movements will affect the asset's market value prior to realization. As with loan defaults, this risk is distributed to parties of a securitization transaction differently, depending on the transaction's structure. If the SPE's securities also carry fixed rates, interest rate risk will pass to SPE security holders. If the securities are floating rate, the risk will pass to holders of the SPE's remainder interest, typically the originator firm. Third, there is prepayment risk. Most borrowers may repay loans early and thus avoid further interest costs. As with the risks discussed earlier, this risk of loss of future cash flows is distributed through the securitization structure to the parties to a securitization transaction. A number of structuring mechanisms are available, including third party guarantees, provisions that contingently wind down the securitization structure in the case of too much early prepayment, and provisions that allow for the transference of additional loan assets that replace those that are paid off. The latter mechanism has spawned an entirely new securitization business by permitting typically short-lived receivables, such as credit card loans, to be securitized.
A Simplified Case Example Asset securitization transactions are often complex. They involve a linked group of contracts that often take several years to fully execute.
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Unfortunately, the complexity of real case examples may be difficult to utilize within the constraints of classroom space, facilities, and time. The following simple case attempts to provide a format for discussion of many of the accounting issues and problems associated with asset securitization while abstracting sufficiently from details that are not germane to a fundamental discussion. The case involves Fair-and-Square, a corporation with publicly traded stock, that seeks to raise funds for the financing of receivables obtained through sales as a normal part of its business. The business begins with $100,000 initial capital raised through the sale of stock ($50,000) and long term debt (£50,000) that carries an interest rate of 8% per annum. Fairand-Square engages in the automobile retailing business, buying and selling cars. The business initially invests its $100,000 of capital in inventory. In the first year, it sells all of its inventory on account, at a markup o f 50%, with interest due on receivables of 10% per annum. The historical default rate on receivables is 2% of sales. Other operating expenses equal $8000. The balance sheet and income statement of Fairand-Square at the end of the first year is thus: Balance sheet ($) Cash Receivables, net
3000 147,000
Noncurrent debt Equity
50,000 100,000
Income statement ($) Revenue: Sales 150,000 Interest income 15,000 Total revenue
165,000
Expenses: COGS Bad debt expense Interest exp Other oper exp Total expenses
100,000 3000 4000 8000 115,000
Net income
50,000
In the second year, because business is growing, Fair-and-Square has an opportunity to sell $150,000. of new merchandise on account, with all terms and costs the same as in the first year. To finance the new loans that will be made, the company has three options. It can: (1) issue new equity, (2) borrow more money, or (3) securitize some of its assets using securitization technology. Fair-and-Square, perhaps partly because it is a new business, does not carry an investment grade rating from bond rating services such as Moody's. Because of this, many potential lenders, such as mutual funds, cannot buy Fair-and-Square's debt securities because they are contractually required to invest only in debt that is investment grade. In addition, less restricted lenders such as banks that are able to lend to
Accounting for Asset Securitization Transactions
43
Fair-and-Square want to charge a relatively high interest rate to cover the increased risk of default from dealing with a new firm. Asset-backed debt securities created through a securitization transaction, because they will be issued by a separate legal entity that is dedicated to the transaction, could carry an investment grade rating irrespective of the credit rating of Fairand-Square. 2 Because the investment risk associated with asset-backed debt is low, the associated interest on principal that investors in assetbacked debt require is also low. Securitization would thus benefit Fairand-Square by (1) opening up a whole new source of financing that was previously unavailable, and (2) reducing the costs that Fair-and-Square must incur to finance its growth, relative to the costs of borrowing directly or issuing new stock. For these reasons, Fair-and-Square decides to securitize its year 1 portfolio of auto loan receivables by "selling" them to a special purpose trust called SPT. SPT issues debt-like securities backed by the cash flows of the transferred receivables. It will pay the proceeds of the sale of securities back to Fair-and-Square. In addition, Fair-and-Square will receive a 1% fee for servicing the securitized loans. To secure a lower cost of credit, Fair-and-Square also provides SPT with: (1) a recourse agreement to cover all loan defaults up to 10% of transferred assets; and (2) dedication of the spread account that will accumulate all of SPT's net fund inflows and be available to cover any credit defaults. Excess funds not used for defaults will be repaid to Fair-and-Square as a remainder interest, at the end of the securitization transaction. As mentioned earlier, the expected default rate on auto loan portfolios of this type and quality are 2%. Defaults have never exceeded 10%, however, even in the worst economic conditions. The securities issued by SPT are: $150,000 of an 8%, fixed rate, security with maturity of 5 years; and the "remainder" security representing an interest in the spread account. The fixed rate securities are all sold at par. To simplify the transaction, assume the following. First, assume all sales are made on the first day of each new accounting year. In addition, all new loan receivables originated by the company are long-term obligations with no principle repayments required until the third year. Second, all other costs, interest rates, etc., are the same as in the first year, and there is no income tax. Third, consistent with the case example, securitization is assumed to be income neutral, at least with respect to reportable income, in accordance with the reporting practices of numerous firms that securitize. 2Asset-backed debt typically is awarded the highest investment rating possible (AAA/Aaa). Because of recourse and servicing agreements, the originator firm's credit quality does have a minor role in determining the investment rating of asset-backed debt. The impact, however, is negligible in comparison to directly issued securities.
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Securitization transactions are currently reported as either sales or loans under G A A P . Based on the above information, if the securitization financing was treated as a form of collateralized lending, the year 2 balance sheet and income statement for Fair-and-Square would be as follows: Balance sheet ($) Cash Receivables, net
16,500 367,500
Debt, noncurrent Equity
200,000 184,000
Income statement ($) Revenue: Sales Interest income
225,000 37,500
Total revenue
262,500
Expenses: COGS Bad debt expense Interest exp Other oper exp Total expenses
150,000 4500 16,000 8000 178,500
Net income
84,000
Assuming that the securitized assets are treated as sold by Fair-andSquare, the year 2 income statement and balance sheet would be as follows: Balance sheet ($) Cash Receivables, net Sp read interest
15,000 220,500 1500
Debt, noncurrent Recourse Liability Equity
50,000 3000 184,000
Income statement ($) Revenue: Sales Excess fees Service fees Interest income
225,000 1500 1500 22,500
Total revenue
250,500
Expenses: COGS Bad debt expense Interest exp Other oper exp Total expenses
150,000 4500 4000 8000 166,500
Net income
84,000
The case above raises a number of intriguing accounting questions that m a y be used to engage students in a discussion of the case. Some of these questions, which are discussed in the next section, include the following: Should the securitized assets be treated as sold by Fair-and-Square?
Accounting for Asset SecuritizationTransactions
45
Alternatively, should the issuance of asset-backed debt by SPT be reported as new loans by Fair-and-Square? In this transaction, who bears the economic benefits and risks of loss inherent in securitized assets? Who "controls" a special purpose trust? Is control a valid criterion for determining whether sales treatment is appropriate? What are the rights and obligations that investors in asset-backed debt and Fair-and-Square hold in the special purpose entity? Should these be reported? If they are reported, how would they be measured? How would they be classified under the traditional accounting model? When should expected excess fees be recognized as income--as earned or when the transfer of the securitized loans from Fair-andSquare to the SPE takes place? How and when should future transfers of new loans, which Fair-andSquare is obliged to transfer, be recognized? How and when should associated excess fees be recognized? Assuming that the remainder spread account is an asset, should expected defaults be netted against the value of expected excess fees? What if default and/or repayment rates, change? If these changes trigger contractual clauses that call for early termination of a transaction, or new rights and obligations among the parties, how and when should such events be accounted for?
A C C O U N T I N G P R O B L E M S A N D ISSUES Sale or Loan
First and foremost, should the securitized assets be treated as sold? There has been, after all, a legal transfer of title so that the trust now explicitly bears the risk of loss. On the other hand, because of the recourse agreement and dedication of all spread moneys, the originator firm arguably still bears much, if not all, of the economic risk of loss inherent in the securitized assets. Alternatively, the originator firm may be viewed as simply providing a security interest in securitized assets. Securitized assets, however, have been compromised both with respect to title and future economic resources. How much compromise must occur before collateralized loan treatment is no longer a credible reporting method? Trusts used in securitization are very flexible as to structure and can easily accommodate the whole spectrum of variation between the extremes of an all out sale or loan.
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Who Controls a Trust?
One possibility is to use control as a criterion to decide whether the transaction is a sale or loan, perhaps in a manner similar to the way the criterion is applied to determine whether subsidiaries should be consolidated. The originator firm no longer controls the loan portfolio, and is no longer the legal owner. On the other hand, the trust agreement is usually prepared and executed by the originator firm and, as such, presumably reflects, at least at the beginning of the transaction, the will of the transferor. Further, in consolidations, because common shares have voting rights, corporate control can be measured by examining the degree of equity interest. In trusts, however, there is no clear equivalent of "equity". Control is solely a function of the contractual agreements that are part of the trust agreement. The remainder interest is that of a beneficiary, often with no discretionary power over the trust or its assets attached, as with corporate equity. Further, the remainder interest is often only nominal. Further, it is possible, even likely, that no beneficiary or grantor has control but, instead, control has been vested to a trustee as fiduciary of the trust corpus.
Economic Benefits and Risks of Loss
A related question for discussion is who bears the economic risks and benefits inherent in the securitized assets? Clearly the trust claim holders now have some interest in the cash flows of securitized assets. On the other hand only the most senior, and most certain, cash flows have, in an economic sense, been relinquished to investors to support principle and interest payments on trust claims. Further, most of the risk of loss inherent in the securitized assets is retained by the transferor firm.
Trust Interests and the Accounting Model
In addition to the problem of what sales and loans are, the basic accounting notions of assets and liabilities can also be challenged within the case described above. For example, with respect to recourse that the firm has provided, is this guarantee now a future liability similar to warranty expense? If so, then how should the remainder spread account be recognized since it will first absorb any credit losses and it is likely that there will be sufficient excess funds to cover such losses. As another example, consider that the legal characteristics and basic structures o f trusts are very different from that of corporations. This may cause problems in classifying securitization interests as assets, liabilities or equity. There are no distinctions as to equity and liability claims in trust agreements. Instead, there are grantors, beneficiaries, and
Accounting for Asset Securitization Transactions
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fiduciaries, each with contractual obligations and rights that are intermingled in a complexly linked group of contracts. H o w will such rights and obligations be reported under a corporate-based accounting model? Is the current definition of assets, liabilities, and equity, rich enough for such a task?
Non-executory Contract Interests and Contingencies In addition to all of the issues above, the familiar problems with historical-cost accounting also appear under asset securitization. First, there is the problem of non-executory contracts. If assets are economic resources with the potential to provide future benefits to the firm, then should the originator firm's right to service trust assets be recognized as an asset? I f so, what value should be placed on this resource, and how can it be measured? Similarly, should future interest income be recognized as an asset? In a true sale, future cash flows are purchased by an unrelated third party in an arms length transaction, presumably for the cash flows' present value. Here, however, the SPE has received full title to securitized assets, thus receiving a full, vested interest in the assets. The originator firm, however, still retains an economic interest in the SPE and its future cash flows via the spread account. Is this a true and complete sale to an unrelated third party? Future interest income on securitized assets has also not yet been earned or received. Should it be recognized as sold? Second, there is the problem of contingency events. W h a t if default rates change subsequent to the start of a securitization transaction. Securitization trust agreements often provide for numerous subsequent contingencies such as this. Will these be recognized by a reporting system that has, as its objective, the issuance of a single set of financial reports? If so, in what way? Securitization has also proven to be a very innovative, fast-paced technology. Will standard-setters create rules as fast as the markets can change? Finally, there are the traditional problems of relevancy when historical costs are used and market values of assets are volatile. If the SPE's loan assets and liabilities are mismatched with respect to yield and maturity, interest rate risk may create large wealth effects for the originator firm. H o w and when should these be reported, at the conclusion of the transaction or at occurrence? Note that securitization transactions are much more complex and can take more time to execute than when a single asset is held by one owner. H o w relevant will information be that is delayed with respect to recognition for so long a time?
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A C C O U N T I N G S T A N D A R D S A P P L I C A B L E TO SECURITIZATIONS The accounting standards that have previously been applied to securitizations primarily followed legal form as opposed to economic substance. Two possibilities have existed under generally accepted accounting principles (GAAP). First, under SFAS 77 (Reporting by transferors for transfers of receivables with recourse)(Financial Accounting Standards Board, 1983) the transaction was viewed as a sale of securitized assets by the originator firm to the SPE. Securitized assets were thus removed from the originator firm's balance sheet with cash increased in an amount typically equal to the face amount of the transferred assets. The remainder interest in the SPE that is retained by the originator firm was then recognized as an asset on that firm's books. In addition, the estimated value of any recourse agreement was typically recognized as a liability in the financial statements. However, any interest in the future interest and earnings of the sold assets was not typically recognized at time of sale. The primary qualification for sales treatment under SFAS 77 was that a transfer must, in the documentation, " p u r p o r t " to be a sale. Additional qualifying criteria included the following: (1) the control of the assets had been transferred (i.e., no call provisions available to the SPE); (2) any recourse back to the seller could be reasonably estimated; and (3) the transferee could not require the transferor to repurchase the receivables (i.e., no put provisions available to the SPE). The transaction also had to involve some recourse back to the originator firm. The second possibility was that the securitization could purport to be a collateralized loan. In this case, the transaction was normally treated as a loan collateralized by a perfected security interest in the securitized assets. Securitized assets remained on the balance sheet and a liability was reported by the originator firm. The applicable accounting treatment was codified by Technical Bulletin 85-2 (Accounting for collateralized mortgage obligations), which provided such treatment for securitization transactions that are, in form, loans. The bulletin was originally applicable only to collateralized mortgage obligations. The bulletin's scope, however, was expanded to include all securitization transactions that take the express form of a loan. Technical Bulletin 85-2 allowed for sales treatment in a securitization transaction only if: (1) virtually all cash flows from the assets were irrevocably transferred to lenders; (2) the originator firm could not call the obligations or substitute for them; (3) no recourse or liability by the originator firm was permitted for the transaction; and (4) there were no requirements to redeem obligations early. SFAS 77 and Technical Bulletin 85-2, because they relied so heavily on the form of securitization transactions, led to numerous comparative anomalies in the way securitizations are accounted for across firms. By
Accounting for Asset SecuritizationTransactions
49
structuring securitizations somewhat differently, a transaction that yielded the exact same economic substance with respect to the distribution of rights, benefits, and risks inherent in securitized assets could be reported as a sale by one firm and as a loan by the other. One case exercise that is useful here is to have students analyze balance sheets and income statements for each possibility-sales and loan treatment. Ratio analysis will reveal that if firm B elects to use the sales treatment, it will appear more profitable and less risky, at least with respect to its leverage ratio and ROA, than firm A, even with the assumption that both firms bear the same economic benefits and risk from the new financing. Irrespective of which accounting treatment was used, SFAS 77 or Technical Bulletin 85-2, disclosures were also required for securitization transactions. SFAS 105 (Disclosure of information about financial instruments with off balance-sheet risk and financial instruments with concentrations of credit risk)(Financial Accounting Standards Board, 1990) requires that information concerning off-balance sheet "financial instruments" be disclosed in the footnotes of financial statements. "Financial instruments" is interpreted broadly and includes numerous securitization interests such as loan commitments, letters of credit, financial guarantees, recourse obligations, futures contracts, options, and interest rate caps and floors. SFAS 119 (Disclosure about derivative financial instruments and fair value of financial instruments) expands on SFAS 105 by requiring disclosure for many newer derivative instruments as well as requiring classification of off-balance sheet 1terns. NEWLY ADOPTED ACCOUNTING TREATMENT A newly issued accounting standard, SFAS 125, entitled "Accounting for transfers and servicing of financial assets and extinguishments of liabilities" (Financial Accounting Standards Board, 1996), will supersede accounting treatments codified by SFAS 77 and Technical Bulletin 85-2 (Financial Accounting Standards Board, 1985). The statement shall be effective for all transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996. 3 The standard codifies an approach, hereafter labeled "financial components", whereby most securitizations will be treated as sales. This approach, however, attempts to resolve some of the problems concerning sales treatment by explicitly recognizing all component interests that parties to a securitizaton may have in the SPE. Such components might include call options, put options, rights to service assets, forward sales agreements, spread accounts, 3SFAS 127 (Deferral of the effectivedate of certain provisions of FASB Statement 125) defers for 1 year the effective date for repurchase agreements, dollar-roll, securities and similar transactions.
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interest-only strip receivables, recourse agreements, and futures contracts and options. The financial components approach is thus aimed at more fully capturing the economic substance of complex and conditional transactions such as securitizations. By recording securitization events "piecemeal" a number of benefits may occur, including: (1) the reporting o f more complete data, (2) the avoidance of distortions caused by forcing hybrid transactions to be characterized as a complete sale or loan, and (3) the more complete reporting of economic benefits and obligations associated with securitization transactions. While promising, the new standard raises a number of questions and leaves many fundamental issues unresolved. First, because components would be recognized in piecemeal fashion, information about the components' relationship to each other, including their origination from the same transaction, would necessarily be lost. Since the major innovation in securitization is the partitioning of assets using a separate entity, it follows that most o f the relevant information about the net benefits and risks of using securitization would be lost. Second, while all interests arising from securitization would be reported, many of the components would still not fit the traditional definitions of assets, liabilities and equity, as discussed earlier. Because of this, financial components, instead of acting to resolve reporting anomalies, may actually magnify these problems. Third, many components would not have established markets in which to measure their cost and value. In some cases, this problem is not serious if a model exists with which to make a reasonable estimate. On the other hand, for a number of untraded financial components, there are no currently available valuation models that apply. Fourth, the new standard utilizes the criterion of "effective control" to determine whether sales treatment is warranted. The concept, as it applies to most securitizations, essentially requires the SPE to be fully isolated from the transferor and its creditors. This legalistic criterion is potentially far removed from the traditional risk/rewards concept that has, in the past, determined when a sale has occurred. As such, questions arise about how effective financial reports prepared under the new standard will be in providing information about the economic substance of securitizing firms' business activity. Finally, the new standard requires the use of (1) historical cost numbers for "beneficial interests" in the SPE that are retained by the transferor firm, and (2) market values for "assets obtained and liabilities incurred" through a securitization transaction. 4 The technique makes sense if the components borne from a securitization transaction are viewed as preexisting, i.e., that securitization repackages
4The carrying value of the transferred receivables are allocated to the various financial components created in the transaction using market values as weights.
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the benefits a n d risks i n h e r e n t in the original assets into c o m p o n e n t s , s o m e o f which are sold a n d o t h e r s r e t a i n e d by the t r a n s f e r o r firm. O n the o t h e r h a n d , the p r o c e s s c o u l d a r g u a b l y be c r e a t i n g entirely new assets with u n i q u e benefits a n d risks. F o r e x a m p l e , securitization creates m a n y new types o f d e r i v a t i v e securities, each with different m a r k e t i n g characteristics a n d l i q u i d i t y t h a t m a y be greater, in sum, t h a n existed when the assets were p a r t o f a n u n d i v i d e d whole. I f so, all o f the assets could be viewed as u n i q u e f o r m s t h a t did n o t p r e v i o u s l y exist, suggesting t h a t they all be r e c o r d e d at m a r k e t value. T h e definitions o f "beneficial interests r e t a i n e d " a n d "assets o b t a i n e d a n d liabilities incurred are thus a r b i t r a r y , being d e p e n d e n t chiefly on the perspective o f the user. Yet S F A S 125 p r o v i d e s for different v a l u a t i o n m e t h o d s for each c a t e g o r y , an a p p r o a c h t h a t c o u l d lead to inconsistent a n d n o n c o m p a r a b l e results. REFERENCES Financial Accounting Standards Board (1983). Reporting by transferors for transfers of receivables with recourse. Statement of Financial Accounting Standards No. 77, Stanford, CONN: FASB. Financial Accounting Standards Board (1985). Accounting for collateralized mortgage obligations. Technical Bulletin 85-2. CT. Financial Accounting Standards Board (1990). Disclosure of information about financial instruments with off balance-sheet risk and financial instruments with concentrations of credit risk. Statement of Financial Accounting Standards No. 105. CT. Financial Accounting Standards Board (1996). Accounting for transfers and servicing of financial assets and extinguishments of liabilities. Statement of Financial Accounting Standards No. 125. CT. Imhoff, E. A. (1992). Asset securitization: economic effects and accounting issues Accounting Horizons, 6 (March), 5-16. Jablansky, P. (1993). A new look at the asset backed securities market. Goldman Sachs Fixed Income Research, 1-34. Kane, G. (1995). Accounting for securifized assets CPA Journal, July, 1-3. Perry, Raymond (1993). Accounting for securitizations Accounting Horizons, 7 (September), 71-82. Swieringa, Robert J. (1989). Recognition and measurement issues in accounting for securitized assets Journal of Accounting Auditing and Finance, 169-186.
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Pergamon
PII: S0748-5751(96)00039-5
THE
PROBLEM
OF
HOW
TO
SECURITIZATION
ACCOUNT
FOR
ASSET
TRANSACTIONS
Gregory D. Kane UNIVERSITY O F D E L A W A R E Abstract: Asset securitization is a sophisticated new financial tool that has enabled increasing
numbers of firms to liquefy their balance sheets and find alternative sources of investment capital. The purpose of this paper is to highlight some of the fundamental accounting problems associated with asset securitization. A simple case is presented that can be used as a basis for discussions about how to account for asset securitization transactions. A description of asset securitization, as well as current and prospective treatment alternatives, is also provided. © 1997 Elsevier Science Ltd
INTRODUCTION A s s e t securitization is a s o p h i s t i c a t e d new financial tool t h a t has e n a b l e d increasing n u m b e r s o f firms to liquefy their b a l a n c e sheets a n d find a l t e r n a t i v e sources o f i n v e s t m e n t capital. T o d a y h u n d r e d s o f firms engage in s e c u r i t i z a t i o n t r a n s a c t i o n s . A s a result, yearly new issues o f a s s e t - b a c k e d securities have e x p o n e n t i a l l y increased f r o m j u s t 1.237 billion in 1985 to o v e r 130 billion by 1993 ( J a b l a n s k y , 1993). A whole range o f assets can n o w be securitized, including leases, credit c a r d receivables, c a r loans, a n d c o m m e r c i a l loans. S e c u r i t i z a t i o n t r a n s a c t i o n s raise a n u m b e r o f intriguing c o n c e p t u a l q u e s t i o n s c o n c e r n i n g the m e a n i n g o f sales, assets, a n d the r e p o r t i n g entity.l T h e y also b r i n g to the f o r e f r o n t a n u m b e r o f f u n d a m e n t a l issues t h a t h a v e p l a g u e d historical cost a c c o u n t i n g for a long time: i.e., t r e a t m e n t o f n o n - e x e c u t o r y contracts, c o n t i n g e n c y events, a n d how, o r whether, to m e a s u r e wealth c h a n g e s t h a t are n o t t r a n s a c t i o n - d r i v e n . A c c o u n t i n g for s e c u r i t i z a t i o n can thus be a very useful, c o m p r e h e n s i v e , t o p i c in the c l a s s r o o m , especially when case discussion a n d o t h e r m e t h o d s o f interactive teaching a r e applied. T h e topic p r o v i d e s an o p p o r t u n i t y to e n g a g e s t u d e n t s to t h i n k b e y o n d the m e c h a n i c s o f j o u r n a l entries a n d trial b a l a n c e s a n d i n s t e a d c o n s i d e r the basic c o n c e p t s a n d objectives t h a t u n d e r l i e the r e p o r t i n g process, including the extent to which c u r r e n t a n d ~A number of articles in the literature have discussed some of the conceptual problems with securitization. These include Kane (1995), Perry (1993), Imhoff (1992), and Swieringa (1989). 39
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proposed accounting methods can capture the economic substance of complex and quickly changing forms of business activity. The purpose of this paper is to highlight some of the fundamental accounting problems associated with asset securitization. A simple case is presented that can be used as a basis for discussions about how to best account for asset securitization transactions. A description of asset securitization, as well as current and proposed treatment alternatives, is also provided. BACKGROUND Asset securitization occurs when a company (hereafter, the originator firm) transfers a portfolio of assets, typically loans, to a special purpose entity (hereafter, SPE), which is usually a trust. The SPE is established by the company solely for the purpose of conducting a securitization transaction. The SPE then issues securities which may take a form similar to fixed or floating rate debt, equity, or some combination thereof The proceeds the SPE receives from the sale of securities are then transferred back to the originator firm. As loan and interest payments from the securitized loans are paid in to the SPE, the trust uses these funds to pay SPE security holders' claims. The SPE may also pay the originator firm a service fee for managing securitized loans. The transaction proceeds until all of the SPE's obligations, including security holders' claims, have been discharged. Any cash received in excess of that required to service securitized assets and pay security holder claims (hereafter, the spread) is typically accumulated by the SPE and, at the conclusion of the transaction, paid to the holder of the remainder interest, usually the originator firm. Securitization technology offers a number of important advantages. In particular, the financing obtained by the SPE is little affected, with respect to credit quality, by the credit rating of the originator firm. This is because the securities backed by securitized assets are issued by a legally separate and distinct entity (i.e., the SPE). This advantage can permit firms with low credit quality to finance new business at low cost, AAA investment grade, interest rates. In addition, securitizations can be flexibly structured to take the form of, and qualify as sales, under regulatory accounting procedures (RAP) and generally accepted accounting procedures (GAAP). As a result, off balance sheet financing can be attained through securitization, thus improving firms' leverage ratios and thereby reducing overall capitalization requirements. This has the effect of lowering the overall cost of capital while increasing the leverage potential of a given asset base. Finally, because trusts are so flexible as to structure, securitization can be used to create hybrids of equity/debt interests that are tailored to fit the needs of specific groups of investors. As with most transactions that involve the receipt of future cash flows as well as future contractual performance, a number of risks are associated
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with securitization transactions. These include the risk of credit default, interest rate or market risk, and prepayment risk. First, consider the risk of loan default. If transferred loans default or do not pay in timely fashion, the SPE may have insufficient funds to pay security holder claims as well as other obligations. How this risk is spread among parties to a securitization transaction is determined by the structure of a securitization transaction. To insure the highest possible credit rating, and lowest possible financing cost, the risk of credit default is often absorbed by the originator of a securitization transaction. The way this is accomplished is through the use of a variety of "credit enhancement" mechanisms including: (1) the dedication of the spread account so that it first absorbs losses from credit defaults, (2) the provision of direct recourse by the SPE back to the originator firm with respect to losses from loan defaults; (3) the holding by the originator firm of a subordinate interest in the SPE and its securitized assets; and (4) the provision of a cash collateral account and/or dedicated credit lines that can be used when SPE cash outflows temporarily exceed inflows, thus allowing for options other than immediate foreclosure of bad debt. In addition, the SPE sometimes purchases guarantees and letters of credit from third parties other than the originator firm to further protect against the risks of loan default. Second, there is interest rate, or market risk. When any loan asset has a fixed rate or return, interest rate movements will affect the asset's market value prior to realization. As with loan defaults, this risk is distributed to parties of a securitization transaction differently, depending on the transaction's structure. If the SPE's securities also carry fixed rates, interest rate risk will pass to SPE security holders. If the securities are floating rate, the risk will pass to holders of the SPE's remainder interest, typically the originator firm. Third, there is prepayment risk. Most borrowers may repay loans early and thus avoid further interest costs. As with the risks discussed earlier, this risk of loss of future cash flows is distributed through the securitization structure to the parties to a securitization transaction. A number of structuring mechanisms are available, including third party guarantees, provisions that contingently wind down the securitization structure in the case of too much early prepayment, and provisions that allow for the transference of additional loan assets that replace those that are paid off. The latter mechanism has spawned an entirely new securitization business by permitting typically short-lived receivables, such as credit card loans, to be securitized.
A Simplified Case Example Asset securitization transactions are often complex. They involve a linked group of contracts that often take several years to fully execute.
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Unfortunately, the complexity of real case examples may be difficult to utilize within the constraints of classroom space, facilities, and time. The following simple case attempts to provide a format for discussion of many of the accounting issues and problems associated with asset securitization while abstracting sufficiently from details that are not germane to a fundamental discussion. The case involves Fair-and-Square, a corporation with publicly traded stock, that seeks to raise funds for the financing of receivables obtained through sales as a normal part of its business. The business begins with $100,000 initial capital raised through the sale of stock ($50,000) and long term debt (£50,000) that carries an interest rate of 8% per annum. Fairand-Square engages in the automobile retailing business, buying and selling cars. The business initially invests its $100,000 of capital in inventory. In the first year, it sells all of its inventory on account, at a markup o f 50%, with interest due on receivables of 10% per annum. The historical default rate on receivables is 2% of sales. Other operating expenses equal $8000. The balance sheet and income statement of Fairand-Square at the end of the first year is thus: Balance sheet ($) Cash Receivables, net
3000 147,000
Noncurrent debt Equity
50,000 100,000
Income statement ($) Revenue: Sales 150,000 Interest income 15,000 Total revenue
165,000
Expenses: COGS Bad debt expense Interest exp Other oper exp Total expenses
100,000 3000 4000 8000 115,000
Net income
50,000
In the second year, because business is growing, Fair-and-Square has an opportunity to sell $150,000. of new merchandise on account, with all terms and costs the same as in the first year. To finance the new loans that will be made, the company has three options. It can: (1) issue new equity, (2) borrow more money, or (3) securitize some of its assets using securitization technology. Fair-and-Square, perhaps partly because it is a new business, does not carry an investment grade rating from bond rating services such as Moody's. Because of this, many potential lenders, such as mutual funds, cannot buy Fair-and-Square's debt securities because they are contractually required to invest only in debt that is investment grade. In addition, less restricted lenders such as banks that are able to lend to
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Fair-and-Square want to charge a relatively high interest rate to cover the increased risk of default from dealing with a new firm. Asset-backed debt securities created through a securitization transaction, because they will be issued by a separate legal entity that is dedicated to the transaction, could carry an investment grade rating irrespective of the credit rating of Fairand-Square. 2 Because the investment risk associated with asset-backed debt is low, the associated interest on principal that investors in assetbacked debt require is also low. Securitization would thus benefit Fairand-Square by (1) opening up a whole new source of financing that was previously unavailable, and (2) reducing the costs that Fair-and-Square must incur to finance its growth, relative to the costs of borrowing directly or issuing new stock. For these reasons, Fair-and-Square decides to securitize its year 1 portfolio of auto loan receivables by "selling" them to a special purpose trust called SPT. SPT issues debt-like securities backed by the cash flows of the transferred receivables. It will pay the proceeds of the sale of securities back to Fair-and-Square. In addition, Fair-and-Square will receive a 1% fee for servicing the securitized loans. To secure a lower cost of credit, Fair-and-Square also provides SPT with: (1) a recourse agreement to cover all loan defaults up to 10% of transferred assets; and (2) dedication of the spread account that will accumulate all of SPT's net fund inflows and be available to cover any credit defaults. Excess funds not used for defaults will be repaid to Fair-and-Square as a remainder interest, at the end of the securitization transaction. As mentioned earlier, the expected default rate on auto loan portfolios of this type and quality are 2%. Defaults have never exceeded 10%, however, even in the worst economic conditions. The securities issued by SPT are: $150,000 of an 8%, fixed rate, security with maturity of 5 years; and the "remainder" security representing an interest in the spread account. The fixed rate securities are all sold at par. To simplify the transaction, assume the following. First, assume all sales are made on the first day of each new accounting year. In addition, all new loan receivables originated by the company are long-term obligations with no principle repayments required until the third year. Second, all other costs, interest rates, etc., are the same as in the first year, and there is no income tax. Third, consistent with the case example, securitization is assumed to be income neutral, at least with respect to reportable income, in accordance with the reporting practices of numerous firms that securitize. 2Asset-backed debt typically is awarded the highest investment rating possible (AAA/Aaa). Because of recourse and servicing agreements, the originator firm's credit quality does have a minor role in determining the investment rating of asset-backed debt. The impact, however, is negligible in comparison to directly issued securities.
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Securitization transactions are currently reported as either sales or loans under G A A P . Based on the above information, if the securitization financing was treated as a form of collateralized lending, the year 2 balance sheet and income statement for Fair-and-Square would be as follows: Balance sheet ($) Cash Receivables, net
16,500 367,500
Debt, noncurrent Equity
200,000 184,000
Income statement ($) Revenue: Sales Interest income
225,000 37,500
Total revenue
262,500
Expenses: COGS Bad debt expense Interest exp Other oper exp Total expenses
150,000 4500 16,000 8000 178,500
Net income
84,000
Assuming that the securitized assets are treated as sold by Fair-andSquare, the year 2 income statement and balance sheet would be as follows: Balance sheet ($) Cash Receivables, net Sp read interest
15,000 220,500 1500
Debt, noncurrent Recourse Liability Equity
50,000 3000 184,000
Income statement ($) Revenue: Sales Excess fees Service fees Interest income
225,000 1500 1500 22,500
Total revenue
250,500
Expenses: COGS Bad debt expense Interest exp Other oper exp Total expenses
150,000 4500 4000 8000 166,500
Net income
84,000
The case above raises a number of intriguing accounting questions that m a y be used to engage students in a discussion of the case. Some of these questions, which are discussed in the next section, include the following: Should the securitized assets be treated as sold by Fair-and-Square?
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Alternatively, should the issuance of asset-backed debt by SPT be reported as new loans by Fair-and-Square? In this transaction, who bears the economic benefits and risks of loss inherent in securitized assets? Who "controls" a special purpose trust? Is control a valid criterion for determining whether sales treatment is appropriate? What are the rights and obligations that investors in asset-backed debt and Fair-and-Square hold in the special purpose entity? Should these be reported? If they are reported, how would they be measured? How would they be classified under the traditional accounting model? When should expected excess fees be recognized as income--as earned or when the transfer of the securitized loans from Fair-andSquare to the SPE takes place? How and when should future transfers of new loans, which Fair-andSquare is obliged to transfer, be recognized? How and when should associated excess fees be recognized? Assuming that the remainder spread account is an asset, should expected defaults be netted against the value of expected excess fees? What if default and/or repayment rates, change? If these changes trigger contractual clauses that call for early termination of a transaction, or new rights and obligations among the parties, how and when should such events be accounted for?
A C C O U N T I N G P R O B L E M S A N D ISSUES Sale or Loan
First and foremost, should the securitized assets be treated as sold? There has been, after all, a legal transfer of title so that the trust now explicitly bears the risk of loss. On the other hand, because of the recourse agreement and dedication of all spread moneys, the originator firm arguably still bears much, if not all, of the economic risk of loss inherent in the securitized assets. Alternatively, the originator firm may be viewed as simply providing a security interest in securitized assets. Securitized assets, however, have been compromised both with respect to title and future economic resources. How much compromise must occur before collateralized loan treatment is no longer a credible reporting method? Trusts used in securitization are very flexible as to structure and can easily accommodate the whole spectrum of variation between the extremes of an all out sale or loan.
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Who Controls a Trust?
One possibility is to use control as a criterion to decide whether the transaction is a sale or loan, perhaps in a manner similar to the way the criterion is applied to determine whether subsidiaries should be consolidated. The originator firm no longer controls the loan portfolio, and is no longer the legal owner. On the other hand, the trust agreement is usually prepared and executed by the originator firm and, as such, presumably reflects, at least at the beginning of the transaction, the will of the transferor. Further, in consolidations, because common shares have voting rights, corporate control can be measured by examining the degree of equity interest. In trusts, however, there is no clear equivalent of "equity". Control is solely a function of the contractual agreements that are part of the trust agreement. The remainder interest is that of a beneficiary, often with no discretionary power over the trust or its assets attached, as with corporate equity. Further, the remainder interest is often only nominal. Further, it is possible, even likely, that no beneficiary or grantor has control but, instead, control has been vested to a trustee as fiduciary of the trust corpus.
Economic Benefits and Risks of Loss
A related question for discussion is who bears the economic risks and benefits inherent in the securitized assets? Clearly the trust claim holders now have some interest in the cash flows of securitized assets. On the other hand only the most senior, and most certain, cash flows have, in an economic sense, been relinquished to investors to support principle and interest payments on trust claims. Further, most of the risk of loss inherent in the securitized assets is retained by the transferor firm.
Trust Interests and the Accounting Model
In addition to the problem of what sales and loans are, the basic accounting notions of assets and liabilities can also be challenged within the case described above. For example, with respect to recourse that the firm has provided, is this guarantee now a future liability similar to warranty expense? If so, then how should the remainder spread account be recognized since it will first absorb any credit losses and it is likely that there will be sufficient excess funds to cover such losses. As another example, consider that the legal characteristics and basic structures o f trusts are very different from that of corporations. This may cause problems in classifying securitization interests as assets, liabilities or equity. There are no distinctions as to equity and liability claims in trust agreements. Instead, there are grantors, beneficiaries, and
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fiduciaries, each with contractual obligations and rights that are intermingled in a complexly linked group of contracts. H o w will such rights and obligations be reported under a corporate-based accounting model? Is the current definition of assets, liabilities, and equity, rich enough for such a task?
Non-executory Contract Interests and Contingencies In addition to all of the issues above, the familiar problems with historical-cost accounting also appear under asset securitization. First, there is the problem of non-executory contracts. If assets are economic resources with the potential to provide future benefits to the firm, then should the originator firm's right to service trust assets be recognized as an asset? I f so, what value should be placed on this resource, and how can it be measured? Similarly, should future interest income be recognized as an asset? In a true sale, future cash flows are purchased by an unrelated third party in an arms length transaction, presumably for the cash flows' present value. Here, however, the SPE has received full title to securitized assets, thus receiving a full, vested interest in the assets. The originator firm, however, still retains an economic interest in the SPE and its future cash flows via the spread account. Is this a true and complete sale to an unrelated third party? Future interest income on securitized assets has also not yet been earned or received. Should it be recognized as sold? Second, there is the problem of contingency events. W h a t if default rates change subsequent to the start of a securitization transaction. Securitization trust agreements often provide for numerous subsequent contingencies such as this. Will these be recognized by a reporting system that has, as its objective, the issuance of a single set of financial reports? If so, in what way? Securitization has also proven to be a very innovative, fast-paced technology. Will standard-setters create rules as fast as the markets can change? Finally, there are the traditional problems of relevancy when historical costs are used and market values of assets are volatile. If the SPE's loan assets and liabilities are mismatched with respect to yield and maturity, interest rate risk may create large wealth effects for the originator firm. H o w and when should these be reported, at the conclusion of the transaction or at occurrence? Note that securitization transactions are much more complex and can take more time to execute than when a single asset is held by one owner. H o w relevant will information be that is delayed with respect to recognition for so long a time?
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A C C O U N T I N G S T A N D A R D S A P P L I C A B L E TO SECURITIZATIONS The accounting standards that have previously been applied to securitizations primarily followed legal form as opposed to economic substance. Two possibilities have existed under generally accepted accounting principles (GAAP). First, under SFAS 77 (Reporting by transferors for transfers of receivables with recourse)(Financial Accounting Standards Board, 1983) the transaction was viewed as a sale of securitized assets by the originator firm to the SPE. Securitized assets were thus removed from the originator firm's balance sheet with cash increased in an amount typically equal to the face amount of the transferred assets. The remainder interest in the SPE that is retained by the originator firm was then recognized as an asset on that firm's books. In addition, the estimated value of any recourse agreement was typically recognized as a liability in the financial statements. However, any interest in the future interest and earnings of the sold assets was not typically recognized at time of sale. The primary qualification for sales treatment under SFAS 77 was that a transfer must, in the documentation, " p u r p o r t " to be a sale. Additional qualifying criteria included the following: (1) the control of the assets had been transferred (i.e., no call provisions available to the SPE); (2) any recourse back to the seller could be reasonably estimated; and (3) the transferee could not require the transferor to repurchase the receivables (i.e., no put provisions available to the SPE). The transaction also had to involve some recourse back to the originator firm. The second possibility was that the securitization could purport to be a collateralized loan. In this case, the transaction was normally treated as a loan collateralized by a perfected security interest in the securitized assets. Securitized assets remained on the balance sheet and a liability was reported by the originator firm. The applicable accounting treatment was codified by Technical Bulletin 85-2 (Accounting for collateralized mortgage obligations), which provided such treatment for securitization transactions that are, in form, loans. The bulletin was originally applicable only to collateralized mortgage obligations. The bulletin's scope, however, was expanded to include all securitization transactions that take the express form of a loan. Technical Bulletin 85-2 allowed for sales treatment in a securitization transaction only if: (1) virtually all cash flows from the assets were irrevocably transferred to lenders; (2) the originator firm could not call the obligations or substitute for them; (3) no recourse or liability by the originator firm was permitted for the transaction; and (4) there were no requirements to redeem obligations early. SFAS 77 and Technical Bulletin 85-2, because they relied so heavily on the form of securitization transactions, led to numerous comparative anomalies in the way securitizations are accounted for across firms. By
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structuring securitizations somewhat differently, a transaction that yielded the exact same economic substance with respect to the distribution of rights, benefits, and risks inherent in securitized assets could be reported as a sale by one firm and as a loan by the other. One case exercise that is useful here is to have students analyze balance sheets and income statements for each possibility-sales and loan treatment. Ratio analysis will reveal that if firm B elects to use the sales treatment, it will appear more profitable and less risky, at least with respect to its leverage ratio and ROA, than firm A, even with the assumption that both firms bear the same economic benefits and risk from the new financing. Irrespective of which accounting treatment was used, SFAS 77 or Technical Bulletin 85-2, disclosures were also required for securitization transactions. SFAS 105 (Disclosure of information about financial instruments with off balance-sheet risk and financial instruments with concentrations of credit risk)(Financial Accounting Standards Board, 1990) requires that information concerning off-balance sheet "financial instruments" be disclosed in the footnotes of financial statements. "Financial instruments" is interpreted broadly and includes numerous securitization interests such as loan commitments, letters of credit, financial guarantees, recourse obligations, futures contracts, options, and interest rate caps and floors. SFAS 119 (Disclosure about derivative financial instruments and fair value of financial instruments) expands on SFAS 105 by requiring disclosure for many newer derivative instruments as well as requiring classification of off-balance sheet 1terns. NEWLY ADOPTED ACCOUNTING TREATMENT A newly issued accounting standard, SFAS 125, entitled "Accounting for transfers and servicing of financial assets and extinguishments of liabilities" (Financial Accounting Standards Board, 1996), will supersede accounting treatments codified by SFAS 77 and Technical Bulletin 85-2 (Financial Accounting Standards Board, 1985). The statement shall be effective for all transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996. 3 The standard codifies an approach, hereafter labeled "financial components", whereby most securitizations will be treated as sales. This approach, however, attempts to resolve some of the problems concerning sales treatment by explicitly recognizing all component interests that parties to a securitizaton may have in the SPE. Such components might include call options, put options, rights to service assets, forward sales agreements, spread accounts, 3SFAS 127 (Deferral of the effectivedate of certain provisions of FASB Statement 125) defers for 1 year the effective date for repurchase agreements, dollar-roll, securities and similar transactions.
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interest-only strip receivables, recourse agreements, and futures contracts and options. The financial components approach is thus aimed at more fully capturing the economic substance of complex and conditional transactions such as securitizations. By recording securitization events "piecemeal" a number of benefits may occur, including: (1) the reporting o f more complete data, (2) the avoidance of distortions caused by forcing hybrid transactions to be characterized as a complete sale or loan, and (3) the more complete reporting of economic benefits and obligations associated with securitization transactions. While promising, the new standard raises a number of questions and leaves many fundamental issues unresolved. First, because components would be recognized in piecemeal fashion, information about the components' relationship to each other, including their origination from the same transaction, would necessarily be lost. Since the major innovation in securitization is the partitioning of assets using a separate entity, it follows that most o f the relevant information about the net benefits and risks of using securitization would be lost. Second, while all interests arising from securitization would be reported, many of the components would still not fit the traditional definitions of assets, liabilities and equity, as discussed earlier. Because of this, financial components, instead of acting to resolve reporting anomalies, may actually magnify these problems. Third, many components would not have established markets in which to measure their cost and value. In some cases, this problem is not serious if a model exists with which to make a reasonable estimate. On the other hand, for a number of untraded financial components, there are no currently available valuation models that apply. Fourth, the new standard utilizes the criterion of "effective control" to determine whether sales treatment is warranted. The concept, as it applies to most securitizations, essentially requires the SPE to be fully isolated from the transferor and its creditors. This legalistic criterion is potentially far removed from the traditional risk/rewards concept that has, in the past, determined when a sale has occurred. As such, questions arise about how effective financial reports prepared under the new standard will be in providing information about the economic substance of securitizing firms' business activity. Finally, the new standard requires the use of (1) historical cost numbers for "beneficial interests" in the SPE that are retained by the transferor firm, and (2) market values for "assets obtained and liabilities incurred" through a securitization transaction. 4 The technique makes sense if the components borne from a securitization transaction are viewed as preexisting, i.e., that securitization repackages
4The carrying value of the transferred receivables are allocated to the various financial components created in the transaction using market values as weights.
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the benefits a n d risks i n h e r e n t in the original assets into c o m p o n e n t s , s o m e o f which are sold a n d o t h e r s r e t a i n e d by the t r a n s f e r o r firm. O n the o t h e r h a n d , the p r o c e s s c o u l d a r g u a b l y be c r e a t i n g entirely new assets with u n i q u e benefits a n d risks. F o r e x a m p l e , securitization creates m a n y new types o f d e r i v a t i v e securities, each with different m a r k e t i n g characteristics a n d l i q u i d i t y t h a t m a y be greater, in sum, t h a n existed when the assets were p a r t o f a n u n d i v i d e d whole. I f so, all o f the assets could be viewed as u n i q u e f o r m s t h a t did n o t p r e v i o u s l y exist, suggesting t h a t they all be r e c o r d e d at m a r k e t value. T h e definitions o f "beneficial interests r e t a i n e d " a n d "assets o b t a i n e d a n d liabilities incurred are thus a r b i t r a r y , being d e p e n d e n t chiefly on the perspective o f the user. Yet S F A S 125 p r o v i d e s for different v a l u a t i o n m e t h o d s for each c a t e g o r y , an a p p r o a c h t h a t c o u l d lead to inconsistent a n d n o n c o m p a r a b l e results. REFERENCES Financial Accounting Standards Board (1983). Reporting by transferors for transfers of receivables with recourse. Statement of Financial Accounting Standards No. 77, Stanford, CONN: FASB. Financial Accounting Standards Board (1985). Accounting for collateralized mortgage obligations. Technical Bulletin 85-2. CT. Financial Accounting Standards Board (1990). Disclosure of information about financial instruments with off balance-sheet risk and financial instruments with concentrations of credit risk. Statement of Financial Accounting Standards No. 105. CT. Financial Accounting Standards Board (1996). Accounting for transfers and servicing of financial assets and extinguishments of liabilities. Statement of Financial Accounting Standards No. 125. CT. Imhoff, E. A. (1992). Asset securitization: economic effects and accounting issues Accounting Horizons, 6 (March), 5-16. Jablansky, P. (1993). A new look at the asset backed securities market. Goldman Sachs Fixed Income Research, 1-34. Kane, G. (1995). Accounting for securifized assets CPA Journal, July, 1-3. Perry, Raymond (1993). Accounting for securitizations Accounting Horizons, 7 (September), 71-82. Swieringa, Robert J. (1989). Recognition and measurement issues in accounting for securitized assets Journal of Accounting Auditing and Finance, 169-186.