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ASC 860-10-40-4E provides guidance on the accounting for transfers of a portion of a financial asset.

Excerpt from ASC 860-10-40-4E

If a transfer of a portion of an entire financial asset meets the definition of a participating interest, the transferor shall apply the guidance in the following paragraph [the sale accounting guidance in ASC 860-10-40-5]. If a transfer of a portion of a financial asset does not meet the definition of a participating interest, the transferor and transferee shall account for the transfer in accordance with the guidance in paragraph 860-30-25-2 [report the transfer as a secured borrowing with a pledge of collateral].

A transfer of a portion of a financial asset that does not satisfy the characteristics of a participating interest cannot be reported as a sale, even if the transfer otherwise meets the conditions in ASC 860-10-40-5 for derecognition. This stringent framework can be attributed, at least in part, to the concerns expressed by the FASB about the appropriate accounting for transfers of portions or components of entire financial assets in its deliberations that led to the issuance of the participating interest guidance.
To be considered a participating interest, a transferred portion of an entire financial asset must satisfy all of the conditions in ASC 860-10-40-6A.

ASC 860-10-40-6A

A participating interest has all of the following characteristics:
  1. From the date of the transfer, it represents a proportionate (pro rata) ownership interest in an entire financial asset. The percentage of ownership interests held by the transferor in the entire financial asset may vary over time, while the entire financial asset remains outstanding as long as the resulting portions held by the transferor (including any participating interest retained by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents) and the transferee(s) meet the other characteristics of a participating interest. For example, if the transferor’s interest in an entire financial asset changes because it subsequently sells another interest in the entire financial asset, the interest held initially and subsequently by the transferor must meet the definition of a participating interest.
  2. From the date of the transfer, all cash flows received from the entire financial asset are divided proportionately among the participating interest holders (including any interest retained by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents) in an amount equal to their share of ownership. An allocation of specified cash flows is not an allowed characteristic of a participating interest unless each cash flow is proportionately allocated to the participating interest holders. In determining proportionate cash flows:
    1. Cash flows allocated as compensation for services performed, if any, shall not be included provided those cash flows meet both of the following conditions:
      1. They are not subordinate to the proportionate cash flows of the participating interest
      2. They are not significantly above an amount that would fairly compensate a substitute service provider, should one be required, which includes the profit that would be demanded in the marketplace.
    2. Any cash flows received by the transferor as proceeds of the transfer of the participating interest shall be excluded provided that the transfer does not result in the transferor receiving an ownership interest in the financial asset that permits it to receive disproportionate cash flows.
  3. The priority of cash flows has all of the following characteristics:
    1. The rights of each participating interest holder (including the transferor in its role as a participating interest holder) have the same priority.
    2. No participating interest holder’s interest is subordinated to the interest of another participating interest holder.
    3. The priority does not change in the event of bankruptcy or other receivership of the transferor, the original debtor, or any other participating interest holder.
    4. Participating interest holders have no recourse to the transferor (or its consolidated affiliates included in the financial statements being presented or its agents) or to each other, other than any of the following:
      1. Standard representations and warranties
      2. Ongoing contractual obligations to service the entire financial asset and administer the transfer contract
      3. Contractual obligations to share in any set-off benefits received by any participating interest holder.
  4. 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.
That is, no participating interest holder is entitled to receive cash before any other participating interest holder under its contractual rights as a participating interest holder. For example, if a participating interest holder also is the servicer of the entire financial asset and receives cash in its role as servicer, that arrangement would not violate this requirement. A set-off right is not an impediment to meeting the participating interest definition. For implementation guidance on the application of the term participating interest, see paragraphs 860-10-55-17I through 55-17N.

At a high level, a participating interest exists when the holder of the transferred interest is entitled to receive cash flows from the underlying financial asset exactly proportionate to its ownership interest. The interest must be exposed to the economic risks and benefits of the underlying asset on a basis that is pari passu with other interest holders. As discussed below, in only very limited circumstances may the holder of a participating interest look to sources other than the underlying financial asset to recoup its investment.

2.4.1 Proportionate allocation of cash flows

The implementation guidance in ASC 860-10-55-17I addresses the fundamental characteristic of a participating interest; namely, that it must entitle its holder to all cash proceeds from the underlying financial asset consistent with its proportionate ownership interest. Any arrangements or contractual terms that may cause the transferee to receive cash flows from the underlying asset that do not align with its proportionate ownership interest is inconsistent with the participating interest definition.

ASC 860-10-55-17I

Paragraph 860-10-40-6A(b) states that an allocation of specified cash flows precludes a portion from meeting the definition of a participating interest unless each cash flow is proportionately allocated to the participating interest holders. Following are several examples implementing that guidance:

  1. In the circumstance of an individual loan in which the borrower is required to make a contractual payment that consists of a principal amount and interest amount on the loan, the transferor and transferee shall share in the principal and interest payments on the basis of their proportionate ownership interest in the loan.
  2. In contrast, if the transferor is entitled to receive an amount that represents the principal payments and the transferee is entitled to receive an amount that represents the interest payments on the loan, that arrangement would not be consistent with the participating interest definition because the transferor and transferee do not share proportionately in the cash flows received from the loan.
  3. In other circumstances, a transferor may transfer a portion of an individual loan that represents either a senior interest or a junior interest in an individual loan. In both of those circumstances, the transferor would account for the transfer as a secured borrowing because the senior interest or junior interest in the loan do not meet the requirements to be participating interests (see paragraph 860-10-40-6A(c)).

One of the implications of this strict proportionality requirement is that the contractual interest rate of a participating interest must equal that of the underlying loan (after taking into account any servicing fee retained by the transferor). Any difference in the contractual rate of interest between the two will create an allocation of cash flows disproportionate to the transferee’s ownership interest, which is inconsistent with the participating interest model.
If the contractual interest rate of an underlying loan is no longer a market rate, the transferred portion will not provide the holder with a contractual yield that allows the transfer to clear at par (i.e., having a purchase price equal to the transferred interest’s par or notional amount). To meet the participating interest requirement in these circumstances, the difference between the current market rate and the underlying loan’s contractual interest rate must be accommodated in the transaction’s purchase price, whose amount will necessarily differ from the transferred portion’s notional amount or ownership interest. The fact that a transfer of a portion of an asset may result in the transferor recording a derecognition gain or loss is not an impediment to satisfying the participating interest rules. See ASC 860-10-55-17K for additional information.
Example TS 2-12 and Example TS 2-13 illustrate the application of this guidance.
EXAMPLE TS 2-12
Transfer of interest in a loan–disproportionate allocation of cash flows
Bank Co previously originated, at par, a $50 million loan to Retail Co having an interest rate of 6%. Bank Co now wants to reduce its exposure to Retail Co by selling a 50% interest in the loan to Investor Co. Based on current market conditions, Investor Co is demanding an 8% return. Using a participation agreement, Bank Co sells a 50% interest in the loan’s principal payments, and a 66.7% interest in the loan’s periodic interest payments, to Investor Co for cash. The interests sold to Investor Co are pari passu with those retained by Bank Co; neither interest has priority over the other in the event of Retail Co’s default or bankruptcy.
Could the interest in the loan sold to Investor Co potentially qualify as a participating interest?
Analysis
Investor Co’s ownership interest in the cash flows from Retail Co’s loan are not proportionate. Its interest in the loan’s principal collections (50%) differs from its interest in the loan’s interest payments (66.7%). Even though the portions sold to Investor Co may otherwise have the attributes of a participating interest, the transfer does not meet the proportionality criterion in ASC 860-10-40-6A(b); therefore, it cannot qualify as a participating interest. Bank Co and Investor Co should account for the transaction as a secured borrowing.

EXAMPLE TS 2-13
Transfer of interests in a loan–proportionate allocation of cash flows
Bank Co previously originated, at par, a $50 million loan to Retail Co having an interest rate of 6%. Bank Co now wants to reduce its exposure to Retail Co by selling a 50% interest in the loan to Investor Co. Based on current market conditions, Investor Co is demanding an 8% return. Using a participation agreement, Bank Co sells to Investor Co a 50% ownership interest in all collections received from the Retail Co loan (principal, interest, prepayment penalties). The interests sold to Investor Co are pari passu with those retained by Bank Co; neither interest has priority over the other in the event of Retail Co’s default or bankruptcy. To obtain the required 8% yield, Investor Co pays a cash purchase price of $22.5 million, representing a discount of $2.5 from its 50% interest in the par amount of the loan to Retail Co.
Could the interest in the loan sold to Investor Co potentially qualify as a participating interest?
Analysis
In this example, Investor Co is entitled to 50% of all the loan’s cash flows, regardless of their legal characterization. Thus the transfer satisfies the proportionality requirement in ASC 860-10-40-6A(b). Assuming that the terms of the underlying participation agreement satisfy the remaining conditions in ASC 860-10-40-6A, the interest in the Retail Co loan sold to Investor Co would qualify as a participating interest.
If the transfer qualifies as a sale under ASC 860-10-40-5, Bank Co would recognize a loss of $2.5 million. The fact that Bank Co would record a loss does not impact the participating interest conclusion.

2.4.2 Compensation for services performed

Provided certain conditions are met, the participating interest model permits cash flows from an underlying financial asset to be allocated as compensation for services. Those conditions are:
  • The fees are not subordinate to the proportionate cash flows of the participating interest.
  • The fees are not "significantly above" an amount that would fairly compensate a substitute service provider, including the profit that a marketplace participant would demand. That is, a servicing fee paid to a participant may not be significantly greater than what would be considered "adequate compensation" determined by the market place (see related definition in ASC 860-50-20).
ASC 860-10-55-17J cites three examples of the cash flows that are considered compensation for services performed:
  • Loan origination fees paid by the borrower to the transferor
  • Fees necessary to arrange and complete the transfer paid by the transferee to the transferor
  • Fees for servicing the financial asset
In practice, ongoing fees owed to the servicer of the underlying financial asset will constitute the principal service-related claim on the asset’s cash flows. In many instances, the servicer will be the participating interest’s transferor. Evaluating whether servicing fees are not significantly above adequate compensation (i.e., whether they either reasonably approximate a market rate, or are below a market rate) involves judgment and consideration of the relevant facts and circumstances.
Question TS 2-3 discusses some of the considerations when making this assessment.
Question TS 2-3
When evaluating the condition in ASC 860-10-40-6A(b)(1)(ii), what should a transferor consider when determining whether its servicing fee is "not significantly above" an amount that would fairly compensate a substitute service provider?
PwC response
The FASB did not define or provide implementation guidance on what is meant by "not significantly above an amount that would fairly compensate a substitute servicer." A reporting entity’s determination of when a servicing fee would represent an amount that is "significantly above" should take into account quantitative as well as qualitative considerations.
Qualitative considerations that a reporting entity should evaluate may include, but are not limited to, (1) the type of financial asset being serviced, (2) the risks associated with providing the servicing function for particular asset types, (3) the servicing agreement’s compensation structure (including consideration of anticipated ancillary income) compared to other agreements in the marketplace and (4) the availability of reliable market information on the asset type being serviced.

A transferor may anticipate recognizing a servicing asset attributable to a transfer of a portion of a financial asset (or the transfer of a portion of a group of assets), assuming that all the conditions for derecognition under ASC 860 are met. Recognition of a servicing asset measured in accordance with the guidance in ASC 860-50 is not necessarily inconsistent with an assertion that the related fee is not significantly above adequate compensation. However, if a transferor of a participating interest believes it is appropriate to record a servicing asset, it should ensure that determination is not inconsistent with its assertion that the fee arrangement will not provide economics significantly above adequate compensation. See TS 6.3.5 for considerations relevant to measuring the fair value of a servicing asset.

2.4.3 Consideration of arrangements constituting recourse

Consistent with the principle that a participating interest represents a proportional, pari passu ownership interest in the underlying financial asset, ASC 860-10-40-6A(c)(4) stipulates that the holders of a participating interest may have recourse against the transferor (and its consolidated affiliates and agents) or other participating interest holders only in connection with the following:
  • Standard seller (transferor) representations and warranties (see ASC 860-10-55-17N for examples)
  • Ongoing contractual obligations arising to service the underlying financial asset and to administer the transfer contract
  • Contractual obligations to share in any set-off benefits received by any participating interest holder
In addition to these forms of recourse, ASC 860-10-55-17M clarifies that a participating interest holder may also be the beneficiary of a credit guarantee written by a third party, even if the transferor pays the guarantee fee.

ASC 860-10-55-17M

Paragraph 860-10-40-6A(c) addresses recourse in a participating interest. Recourse in the form of an independent third-party guarantee shall be excluded from the evaluation of whether the participating interest definition is met. Similarly, cash flows allocated to a third-party guarantor for the guarantee fee shall be excluded from the determination of whether the cash flows are divided proportionately among the participating interest holders.

Provided the guarantor is independent of the transferor or other participants, the recourse arrangement is not considered to violate the requirement that a participating interest represents proportionate, pari passu ownership interest in the underlying financial asset. The logic behind this conclusion is that if the underlying obligor defaults and the guarantor is required to satisfy its obligation, the guarantor would become the holder of the participation interest under its subrogation rights. Consequently, for a third-party guarantee to be excluded from the participating interest assessment, the guarantor, as potential holder of the participating interest, can have no greater rights against the transferor or other participating interest holders than those held by the original participating interest holder. Those rights may not differ from, nor extend beyond, those cited in ASC 860-10-40-6A.

2.4.4 Permissible involvement with a participating interest

Permissible forms of a transferor’s subsequent involvement with a transferred participating interest and/or its holder are limited to:
  • Providing services relating to the underlying financial asset in exchange for a fee
  • Writing recourse to the participating interest holder involving only limited, prescribed contractual representations or obligations (i.e., the three forms cited in TS 2.4.3)
To meet the participating interest definition, a transferor cannot receive a beneficial interest in a transferred portion of an entire financial asset. Nor, as a general rule, may the transferor enter into any other arrangements with the participating interest holder that, when considered all-in, could potentially alter or augment the proportional cash flows that the holder receives (or would otherwise receive) through its interest, exclusive of a third-party guarantee. This restriction may be inferred from ASC 860-20-25-1, which lists the various forms of consideration that a transferor may be required to recognize in connection with a transfer that qualifies for derecognition.

Excerpt from ASC 860-20-25-1

Upon completion of such a transfer, the transferor (seller) shall also recognize any assets obtained or liabilities incurred in the sale, including, but not limited to, any of the following:

  1. Cash
  2. Servicing assets
  3. Servicing liabilities
  4. In a sale of an entire financial asset or a group of entire financial assets, any of the following:
    1. The transferor’s beneficial interest in the transferred financial assets
    2. Put or call options held or written (for example, guarantee or recourse obligations)
    3. Forward commitments (for example, commitments to deliver additional receivables during the revolving periods of some securitizations)
    4. Swaps (for example, provisions that convert interest rates from fixed to variable).

The items in ASC 860-20-25-1(d) are included solely in the context of a transfer of an entire financial asset or a group of such assets that qualifies for derecognition. They are not cited in the context of a transfer involving a participating interest that qualifies for sale accounting. Restricting the forms of acceptable consideration to items (a) through (c) for a participating interest aligns with one of the model’s fundamental characteristics; that each interest in the underlying financial asset be entitled to cash flows from the asset proportionate to its ownership interest.
Example TS 2-14 and Example TS 2-15 illustrate the application of this principle.
EXAMPLE TS 2-14
Transferor’s involvement with a transferred portion of a loan – inconsistent with the participating interest model
Through a participation agreement, Bank Co sells to Investor Co a proportionate, pari passu 50% ownership interest in a $10 million commercial loan. The terms of the participation agreement meet the conditions of a participating interest. However, the purchase price received by Bank Co consists of $4 million of cash and a 20% subordinated interest (a sub-participation) in the transferred participation.
Could the interest in the loan sold to Investor Co potentially qualify as a participating interest?
Analysis
Although the terms of the participation agreement may meet the criteria in ASC 860-10-40-6A viewed in isolation, the sub-participation (a beneficial interest in the transferred portion of the loan) causes the transfer to fail the requirement that a participating interest represent a proportionate ownership interest in the underlying financial asset. Bank Co is entitled to receive 60% of the loan’s cash flows all-in, despite having legally conveyed a 50% ownership interest to Investor Co. The sub-participation introduces disproportionality into the allocation of the loan’s cash flows between the two parties, and thus the transferred portion does not satisfy all of the attributes of a participating interest.

This conclusion is consistent with the view expressed by the FASB in paragraph A18 of SFAS 166: "In a transfer of an entire financial asset or group of entire financial assets, the assets obtained may include a beneficial interest in a transferred financial asset that is similar to a component, but only if a transferor transfers and surrenders control over the entire financial asset or the group of entire financial assets [emphasis added]." Here, Bank Co has transferred only a portion of the loan to Investor Co and has received a beneficial interest in that portion (the sub-participation) as part of the purchase price.
EXAMPLE TS 2-15
Transferor’s involvement with a transferred portion of a loan – inconsistent with the participating interest model
Through a participation agreement, Bank Co sells to Investor Co a proportionate, pari passu 50% ownership interest in a $10 million commercial loan for cash. The participation agreement allows Bank Co to reacquire, at par, the transferred interest from Investor Co if an event of default occurs.
How does the contingent call option affect the analysis of whether the transferred interest has the attributes of a participating interest?
Analysis
To qualify as a participating interest, a transferred portion must entitle its holder to proportionate cash flows from the underlying entire financial asset. All cash flows received from the underlying asset subsequent to the transfer must be divided proportionately among the participating interest holders as discussed in ASC 860-10-40-6A(b).
We believe that the contingent call arrangement violates the proportionality mandate in ASC 860-10-40-6A(b). If the contingency occurs (borrower default), Bank Co may exercise its right to reacquire the transferred interest, in which case Investor Co will receive a payment from a source other than the loan obligor or a third-party guarantor and, importantly, will no longer be exposed to the underlying loan’s credit risk. Conversely, there will be a corresponding increase in Bank Co’s exposure to the loan’s credit risk going forward.

Question TS 2-4 discusses the application of this guidance when a transferee commits to future purchases in specific circumstances.
Question TS 2-4
Originators of revolving lines of credit sometimes sell participations in those lines to one or more investors. In addition to purchasing an interest in the amount funded to-date, each participant frequently commits to purchase a proportional interest in any subsequent advances made by the originator under the credit agreement. Would this commitment, in and of itself, cause the participation agreement to fail the participating interest guidance?
PwC response
No, provided that the terms of each participation sold otherwise comply with the requirements in ASC 860-10-40-6A. The forward commitment does not constitute a beneficial interest held by the transferor in any transferred portions; it simply obligates the participant to make incremental investments in subsequent borrower draws funded by the originator. The commitment enhances the participating interest assertion, as the forward ensures that a participant’s relative interest in the funded loan balance will remain unchanged at any point in time.
On the other hand, we do not believe that a participant must agree to purchase an interest in additional draws on a line of credit to comply with the participating interest requirements. ASC 860-10-40-6A(a) indicates that a transferor’s ownership interest in an entire financial asset may vary over time while the entire financial asset remains outstanding, provided that the portions held by the transferor and transferee at any point satisfy the other characteristics of a participating interest. A participant that purchases an interest in a funded loan (accompanied by no commitment to invest in additional advances) may find that its relative ownership interest in the proceeds (collections) from the loan declines over time, but as long as the participation entitles the transferee to cash flows proportionate to its then-current ownership interest, that fact alone will not prevent the transferred portion from meeting the participating interest rules.

2.4.5 Reconsideration events

While an underlying entire financial asset remains outstanding, the portion of that asset retained by a transferor, and the portion held by each transferee, must continue to meet all of the conditions in ASC 860-10-40-6A to warrant their characterization as participating interests. If a portion of an entire financial asset does not meet the participating interest criteria when transferred, by extension the portion retained by the transferor (and any previously-transferred portions) will no longer qualify as participating interests – even though the previously-transferred portions (and the portion retained) met the definition of a participating interest at the time they were sold.
Example TS 2-16 illustrates this principle.
EXAMPLE TS 2-16
Transfer of a portion of loan that does not meet the participating interest rules–reconsideration implications
Bank Co originates a $50 million commercial loan in 20X1. Later that year, Bank Co sells a 50% participation in the loan to Investor A that satisfies all of the conditions of a participating interest. The transfer qualifies for derecognition based on applying the guidance in ASC 860-10-40-5.
In 20X2, Bank Co sells a 25% participation in the loan to Investor B. However, the transferred participation entitles Investor B to a return disproportionate to its ownership interest in the underlying loan. As such, the interest acquired by Investor B does not satisfy the participating interest definition; specifically, the requirement in ASC 860-10-40-6A(b).
What are the financial reporting implications of Bank Co’s transfer of the interest to Investor B?
Analysis
Because the portion of the loan transferred to Investor B does not qualify as a participating interest, Bank Co must report the participations sold to both Investor B and Investor A going forward, as secured borrowings. This will entail a change in the derecognition accounting previously accorded the interest sold to Investor A.

Bank Co’s retained interest in the underlying loan must meet the definition of a participating interest at all times if the bank intends for the portion transferred to Investor A to be similarly respected as a participating interest. In this example, the interest sold to Investor B is not a participating interest and, therefore, by extension, the 25% portion retained by Bank Co no longer has the attributes of a participating interest. Accordingly, in view of this change in circumstance, Bank Co is required to re-recognize the 50% interest previously transferred to Investor A (at fair value, along with a corresponding liability), consistent with guidance in ASC 860-20-25-8 and ASC 860-20-25-9.
See TS 4.3 for more information about re-recognition accounting.

1As discussed in TS 4, a beneficial interest in a transferred financial asset consists of a right to receive specified cash inflows from that asset held by a trust or other entity (the transferee).

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