FASB's Technical Correction Affects Accounting for Loan Participations
By Christopher Johnson, CPA, Senior Manager, Assurance Services
Periodically, the Financial Accounting Standards Board (“FASB”) issues Accounting Standards Updates (“ASU”) that comprise a host of unrelated topics, as is the case with ASU No. 2019-19 “Technical Corrections and Improvements,” issued in December of 2016. This ASU was effective upon issuance with the exception of six specific amendments considered to have the potential to change current practice and which included transition guidance as a result. Additionally, five of the six amendments required prospective application due to the potential for the use of hindsight with respect to fair value measurements. This article examines one of these: an amendment to “Subtopic 860-20, Transfers and Servicing-Sales of Financial Assets.”
This amendment provides clarification as to the correct manner of determining effective control over financial assets that have been transferred. Although broad in scope, the issue of effective control over transferred financial assets has most notably been applicable in the community banking setting with regards to loan sales, and particularly loan participations which must meet the criteria for sale recognition in order to qualify for presentation on the balance sheet at the net (retained) balance. When the sale criteria are not met, the accounting for such a participation would be consistent with that of secured borrowings, essentially requiring a liability to be recorded by the originating institution representing a debt obligation to the participating institution, and the gross presentation of the loan balance. This can have a number of unintended consequences, including regulatory impact associated with capital maintenance, legal lending limits, and loan concentrations, and can also affect the legal rights of the participating institution in the event the originating institution were to fail.
This is not a new area of focus for the FASB; in fact, over the past decade there have been a number of related changes that sent vendors back to the press to generate revised and conforming participation agreements for their community banking clients. The current FASB guidance contained in ASC 860-10-40 includes the following criteria for recognizing the sale of a participating interest between non-related entities:
- A proportionate (pro rata) ownership interest in an entire financial asset is transferred.
- All cash flows received from the entire financial asset are divided proportionately among the participating interest holders.
- No participating interest holder is entitled to receive cash before any other participating interest holder under its contractual rights as a participating interest holder.
- No party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to pledge or exchange the entire financial asset.
- Available evidence provides reasonable assurance that the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates (that are not bankruptcy-remote entities) included in the (transferor’s) financial statements being presented and its creditors.
- The absence of transferor-imposed or other conditions on a transferee’s right to pledge or exchange that both constrain a transferee from pledging or exchanging and, through that constraint, provide more than a trivial benefit to the transferor. Judgment is required to assess whether a particular condition results in a constraint. Judgment also is required to assess whether a constraint provides a more-than-trivial benefit to the transferor.
An important disclaimer: the above represents a summarized list of just some of the more prevalent considerations for recognition as a sale and application of the accounting typically afforded to most (true) participation arrangements, and is far from all-inclusive. That said, these considerations bear relevance to the determination of effective control over transferred financial assets, which is the aspect of the guidance impacted by the amendment in ASU 2016-19.
Specifically, the amendment affects this determination in circumstances where a contingency may result in a transferor regaining effective control over transferred financial assets. In other words, instances in which sale treatment is initially applied, but because of any number of contingencies that could be present in a participation agreement, circumstances arise which give the transferor the option to reacquire the participating institution’s share of a loan. The amendment clarifies that, in such circumstance, the transferor must consider a) whether it has the unilateral right to purchase a specific transferred financial asset, and b) whether that unilateral right provides a more-than-trivial benefit to the transferor. Regardless of the transferor’s intent, if both conditions are met, the transaction no longer meets the sale criterion and effectively becomes a secured borrowing transaction, complete with the less desirable accounting treatment. This requirement was present prior to ASU 2016-19, although conflicting language prompted the amendment to provide clarification.
While this FASB development may not directly impact your institution, it certainly serves as an important reminder of the significant impact that each sentence or phrase in a sale or participation agreement can have on your financial reporting and regulatory compliance. Regular review of the current language in your agreements is strongly encouraged and, given the technical nature and potential for significant impact of this particular topic, when uncertainties are identified, you’re also encouraged to (you guessed it) ask Marcum!