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5.4 "Failed sale" accounting
Publication date: 30 Sep 2020
us Transfers of financial assets guide
ASC 860-30 provides only high-level guidance to assist reporting entities in applying its secured borrowing accounting model. As ASC 860-30-25-2 indicates, the transferred financial assets continue to be reported on the transferor’s books and measured as if the transfer never took place. The transferee does not record the financial assets obtained, barring subsequent default by the transferor. Any cash exchanged is recognized by its recipient (typically, the transferor of the financial assets) with a corresponding liability to return the cash. The payer derecognizes the cash and books a corresponding receivable from the payee.
The following sections discuss how a transfer of financial assets deemed a "failed sale" should be reported by the transferor under ASC 860-30’s secured borrowing accounting model. Transfers involving repurchase agreements or securities lending transactions are discussed in TS 5.5 and TS 5.7, respectively.
5.4.1 Initial measurement of a “failed sale” liability
Under the secured borrowing accounting model, the transferor of the financial assets (obligor) records any cash received and a corresponding obligation to return (repay) those funds. However, in certain "failed sale" transactions, the transferor receives not only cash but also a beneficial interest in the assets "sold." In these instances, it is not clear whether, in addition to recognizing the cash received, the transferor should also record the beneficial interest at the transaction date.
Question TS 5-6 provides our views on this matter.
Question TS 5-6
Transferor Corp sells a pool of receivables to Bank Co for $50 million cash and a subordinated seller’s interest with a fair value of $10 million. The transfer is required to be reported as a secured borrowing. At the transaction date, should Transferor Corp recognize only the cash received with a corresponding "failed sale" obligation of $50 million or, alternatively, should Transferor Corp recognize both the cash and the seller’s interest, and a corresponding liability of $60 million?
Transferor Corp sells a pool of receivables to Bank Co for $50 million cash and a subordinated seller’s interest with a fair value of $10 million. The transfer is required to be reported as a secured borrowing. At the transaction date, should Transferor Corp recognize only the cash received with a corresponding "failed sale" obligation of $50 million or, alternatively, should Transferor Corp recognize both the cash and the seller’s interest, and a corresponding liability of $60 million?
PwC response
For the following reasons, we believe a transferor should record only the cash received:
- Under ASC 860-30’s secured borrowing model, the transferred financial assets are considered "collateral" pledged to the transferee (lender). In this context, it appears anomalous for the transferor to record an interest in assets conveyed to a transferee (lender) that, from ASC 860-30’s perspective, secure the transferor’s obligation to repay cash "borrowed" from the transferee.
- Recognition of a beneficial interest in transferred assets that remain on the transferor’s balance sheet results in a "double-counting" of sorts – as the source of the beneficial interest’s cash inflows are cash collections on the underlying financial assets that the transferor continues to recognize.
This view aligns with the guidance in ASC 815-10-15-64, which states that a derivative instrument is not subject to the guidance in ASC 815-10 if recognizing both the derivative and a transferred asset accounted for as a financing under ASC 860 would result in counting the same item twice on the transferor’s balance sheet.
5.4.2 Subsequent measurement of a “failed sale” liability
ASC 860-30 is silent regarding how a transferor should subsequently account for the liability recognized in connection with a failed sale transaction. However, consistent with the secured borrowing accounting model, we believe that the transferor should apply the same measurement principles that govern an obligor’s accounting for a debt instrument, including the attribution of interest expense. That is, although the liability results from a transfer of financial assets that does not qualify for derecognition, the obligation should be considered a unit of account separate from those assets. Example TS 5-1 and Example TS 5-2 illustrate the application of this decision principle.
Most transferors report a failed sale liability at amortized cost; however, a transferor may elect to apply the fair value option in ASC 825, Financial Instruments, to a failed sale obligation. Question TS 5-7 provides an illustration for this guidance.
Question TS 5-7
In accordance with a pooling and servicing agreement, Transferor Corp sells a pool of loans to a non-consolidated securitization trust in exchange for $95 million cash and certain of the trust’s beneficial interests. The transfer is required to be reported as a secured borrowing. May Transferor Corp elect to apply the fair value option to the resulting $95 million obligation?
In accordance with a pooling and servicing agreement, Transferor Corp sells a pool of loans to a non-consolidated securitization trust in exchange for $95 million cash and certain of the trust’s beneficial interests. The transfer is required to be reported as a secured borrowing. May Transferor Corp elect to apply the fair value option to the resulting $95 million obligation?
PwC response
Yes, we believe a transferor may apply the fair value option (FVO) to a liability arising from a failed sale transaction. The FVO may be elected for a financial liability other than those listed in ASC 825-10-15-5. Those exceptions do not include a liability arising from a transfer of financial assets accounted for as a secured borrowing.
According to the ASC Master Glossary definition, a financial liability arises from the existence of a contract that, among other things, imposes on one entity an obligation to deliver cash to a second entity. In this example, no loan agreement exists that contractually obligates Transferor Corp to pay principal and interest to the securitization trust. Rather, the liability stems entirely from characterizing (reporting) a transfer of financial assets as a secured borrowing for financial reporting purposes. Under a literal interpretation of the definition of a financial liability, one might conclude that a failed sale obligation is not eligible for the FVO election. However, we believe this applies the definition of a financial liability too narrowly.
The failed sale obligation arises from a transfer of financial assets governed by a contract (the pooling and servicing agreement) that conveyed legal title to a pool of loans to the securitization trust. The trust legally owns the loans and is entitled to receive all of their economics post-transfer. However, for financial reporting purposes, Transferor Corp continues to report the transferred loans on its balance sheet. The failed sale liability gives accounting recognition to Transferor Corp’s obligation to "pass on" or remit to the securitization trust the cash inflows from those loans, in accordance with a contract -- the pooling and servicing agreement. Accordingly, we believe that the failed sale liability recorded by Transferor Corp should be eligible for the FVO election.
Failed sale transactions can encompass a wide array of fact patterns and contractual arrangements. As such, no prescriptive "one-size-fits all" model exists to assist a transferor in determining how a failed sale liability should be accounted for post-recognition. This is particularly true regarding the method used to attribute interest expense to the liability. In all cases, however, the transferor should apply an approach that aligns as closely as possible with the contractual arrangements of the underlying transaction (and reflects the economics that legally inure to the transferor) while also adhering to the secured borrowing framework prescribed by ASC 860.
Example TS 5-1 and Example TS 5-2 illustrate what we believe would be the appropriate accounting for a “failed sale” liability subsequent to initial measurement, given the facts presented.
EXAMPLE TS 5-1
Transfer of a subordinated interest in a loan accounted for as a secured borrowing
Transfer of a subordinated interest in a loan accounted for as a secured borrowing
On January 1, 20X1, Transferor Corp originates a commercial loan to Obligor Co with a balloon payment due at maturity. The loan is issued at par and has the following terms:
Principal amount |
$1,000,000
|
|
Annual coupon rate |
6%
|
|
Payment terms |
Interest-only loan payable annually; principal repaid at maturity |
|
Maturity date |
December 31, 20X4 |
|
Upon origination, Transferor Corp estimates the expected credit losses on the loan based on ASC 326-20 to be $10,000. Transferor Corp records the following entries.
Dr. Loan |
$1,000,000
|
|
Dr. Provision expense – credit loss |
$10,000
|
|
Cr. Cash |
$1,000,000
|
|
Cr. Allowance for credit losses |
$10,000
|
To record the loan and the allowance for credit losses at origination.
On December 31, 20X1, Obligor Co makes a payment to Transferor Corp for the annual interest due. Transferor Corp records the following entry (for purposes of this example, all accrued interest entries have been excluded).
Dr. Cash |
$60,000
|
|
Cr. Interest Income
|
$60,000
|
To record interest income for the year from Obligor Co.
On January 1, 20X2, Transferor Corp sells a 50% subordinated ownership interest in the loan to SI Corp for proceeds of $470,000. The terms of the transferred interest are:
Right to interest payments |
Entitled to 50% of the loan’s 6% annual interest collections. However, interest is payable to SI Corp only after Transferor Corp has first received its 50% interest in such collections. |
Right to principal payments |
Entitled to 50% of the loan’s principal collections. However, the full amount ($500,000) is payable to SI Corp only if Transferor Corp has first received its 50% interest in all interest and principal collections. |
Because the participation sold to SI Corp is subordinated to Transferor Corp’s ownership interest in the loan, the transfer does not satisfy all of the participating interest criteria in ASC 860-10-40-6A. Accordingly, Transferor Corp accounts for the transaction as a secured borrowing and records the following entry.
Dr. Cash |
$470,000
|
|
Cr. Failed sale liability
|
$470,000
|
To record initial receipt of cash for the transfer of the subordinated ownership interest
On December 31, 20X2, Obligor Co makes a payment to Transferor Corp for the annual interest due. Transferor Corp records the following entries.
Dr. Cash |
$60,000
|
|
Cr. Interest Income
|
$60,000
|
To record interest income for the year from Obligor Co.
Dr. Interest expense |
$39,210
|
|
Cr. Cash
|
$30,000
|
|
Cr. Accretion of failed sale liability discount
|
$9,210
|
To record Transferor Corp’s annual interest expense due to the failed sale liability for the year, using the effective interest rate of the obligation.
The effective interest rate would include (1) the contractual interest payments on the loan from Obligor Corp that Transferor Corp is obligated to pass on to SI Corp and (2) the accretion of the failed sale liability discount.
On March 31, 20X3, Transferor Corp determines that there has been a degradation in the credit of the loan to Obligor Co and estimates the allowance for credit losses to be $100,000. Transferor Corp records the following entry.
Dr. Provision expense – credit loss |
$90,000
|
|
Cr. Allowance for credit losses
|
$90,000
|
To record an increase in the allowance for credit losses to $100,000 from $10,000
On December 31, 20X3, Obligor Co makes a payment to Transferor Corp for the annual interest due. Transferor Corp records the following entries.
Dr. Cash |
$60,000
|
|
Cr. Interest Income
|
$60,000
|
To record interest income for the year from Obligor Co.
Dr. Interest Expense |
$39,979
|
|
Cr. Cash
|
$30,000
|
|
Cr. Accretion of failed sale liability discount
|
$9,979
|
To record Transferor Corp’s annual interest expense for the year due to the failed sale liability.
On June 30, 20X4, Transferor Corp becomes increasingly concerned about the credit risk of the loan to Obligor Co and estimates the allowance for credit losses to be $200,000. Transferor Corp records the following entry.
Dr. Provision expense – credit loss |
$100,000
|
|
Cr. Allowance for credit losses
|
$100,000
|
To record an increase in the allowance for credit losses to $200,000 from $100,000.
On December 31, 20X4, the loan’s maturity date, Obligor Co is unable to pay any amount due to Transferor Corp. Through discussions with Obligor Co, it is agreed that Obligor Co will pay Transferor Corp $800,000 on March 31, 20X5 to settle the loan amount. Transferor Corp determines the principal reduction of $200,000 is uncollectible and recognizes a corresponding write-off of the loan’s amortized cost basis. Transferor Corp records the following entries (for simplicity we have ignored any interest that might be due to Transferor Corp).
Dr. Allowance for credit losses |
$200,000
|
|
Cr. Loan
|
$200,000
|
To record a charge-off of the loan’s amortized cost basis of $200,000 due to a reduction in the principal balance being deemed uncollectible.
With respect to the failed sale liability and related interest expense, Transferor Corp would accrue an amount due to SI Corp at December 31, 20X4 consistent with the prior years.
Dr. Interest expense |
$40,811
|
|
Cr. Failed sale liability
|
$30,000
|
|
Cr. Accretion of failed sale liability discount
|
$10,811
|
To record the interest expense due to SI Corp.
Because SI Corp’s ownership interest is subordinate, SI Corp ultimately will absorb first any credit losses on Obligor Co’s loan. However, those legal arrangements do not affect Transferor Corp’s accounting for the failed sale liability (and recognition of related interest expense) until any such losses on the underlying loan are realized. Under ASC 860-30’s secured borrowing accounting framework, Transferor Corp’s failed sale liability is a separate unit of account from its loan to Obligor Co. Since Transferor Corp accounts for the failed sale obligation at amortized cost, to adjust (write down) the carrying value of the liability (or to cease recognition of periodic interest expense at the participation’s contractual rate) in response to an anticipated loss on the underlying loan would be inconsistent with the liability extinguishment provisions in ASC 405-20-40-1.
On March 31, 20X5, Obligor Co makes a payment of $800,000 to Transferor Corp to settle the outstanding loan amount. The relevant balances on Transferor Corp’s books immediately prior to extinguishment of the loan are as follows;
Amortized cost basis of loan |
$800,000
|
Allowance for credit losses |
0
|
Net carrying value of loan |
$800,000
|
Failed sale liability |
$530,000
|
The failed sale liability represents the initial balance of $470,000, plus (1) $30,000 of cumulative accretion of discount and (2) $30,000 relating to SI Corp’s share of the interest on the loan from Obligor Corp that was not paid to SI Corp.
Transferor Corp. would record the following entries to extinguish the loan and settle the failed sale liability.
Dr. Cash |
$800,000
|
|
Cr. Loan
|
$800,000
|
To record the cash received and extinguishment of the loan.
Dr. Failed sale liability |
$530,000
|
|
Cr. Cash (payment to SI Corp)
|
$270,000
|
|
Cr. Gain on extinguishment of failed sale liability
|
$260,000
|
To record cash paid to SI Corp and extinguishment of the failed sale liability
The following tables illustrate how the loan settlement payment was allocated between Transferor Corp and SI Corp, and the components of the extinguishment gain.
Loan settlement amount |
$800,000
|
||
Amounts payable first to Transferor Corp (senior ownership interest in loan): |
|||
Principal amount
|
$500,000
|
||
Interest for 20X4 never paid by Obligor Co
|
30,000
|
(530,000)
|
|
Remaining amount payable to SI Corp |
$270,000
|
EXAMPLE TS 5-2
Transfer of a pool of loans, in exchange for cash and a subordinated seller’s interest, accounted for as a secured borrowing
Transfer of a pool of loans, in exchange for cash and a subordinated seller’s interest, accounted for as a secured borrowing
On January 1, 20X1, Transferor Corp sells a static pool of interest-bearing consumer loans having an aggregate face amount of $100 million to Big Bank in exchange for a cash payment of $90 million and a subordinated seller’s interest (deferred purchase price) for the difference. Transferor Corp continues to service the loans. Under the transfer and servicing agreement, Big Bank is entitled to receive all cash collections on the transferred loans until the bank has recouped its $90 million investment and related interest. Interest is calculated daily, based on a floating cost-of-funds formula and the then-current balance of the bank’s investment in the loan pool.
Transferor Corp accounts for the exchange as a secured borrowing transaction because it has retained a call option on the transferred loans, subject to a cap, that allows it to maintain effective control over the entire transferred portfolio.
How should Transferor Corp account for the transaction?
Analysis
At the transfer date, Transferor Corp would recognize Big Bank’s cash purchase price payment and a corresponding failed sale liability.
Dr. Cash |
$90,000,000
|
|
Cr. Failed sale liability |
$90,000,000
|
The transferred loans would be considered an asset of Transferor Corp, as it has not surrendered control over them. Transferor Corp would continue to reflect the transferred loans on its balance sheet, and account for them in subsequent periods as if the transaction with Big Bank had not occurred.
Transferor Corp would account for the failed sale liability in subsequent periods as if the obligation were a conventional loan. As such, it would recognize related periodic interest expense based on the floating rate charged by Big Bank. In accordance with cash collection and remittance provisions in the transfer and servicing agreement, Transferor Corp would reduce the carrying value of the liability (including accrued interest) as collections on the related receivables are remitted to Big Bank or deposited into a collections account beneficially owned by Big Bank. Because the liability is a unit of account separate from the transferred loans, it would be inappropriate for Transferor Corp to attribute anticipated or realized losses arising from the underlying loans to the carrying value of the obligation.
As a consequence of the failed sale, Transferor Corp would not recognize its seller’s interest in the transferred loans. Also, since the call option prevents sale accounting, it is scoped out of ASC 815-10-15-63 and is not recognized separately from the financing (see DH 3.2). However, the secured borrowing accounting model nonetheless captures the economics of this subordinated interest. In its financial statements, Transferor Corp would continue to measure and report the loans as if the transfer had never occurred. Treating Big Bank’s interest in the loans as a secured borrowing allocates to the bank its entitlement to the loans’ economics. The difference between the return on the loans reported in Transferor Corp’s income statement and the interest expense attributed to Big Bank represents the spread income that inures to Transferor Corp through its subordinated -- albeit unrecognized -- interest in the transferred loan portfolio.
As observed in these examples, a failed sale liability should be considered an obligation (unit of account) distinct from the underlying transferred financial asset. Accordingly, as a general rule, we believe that the measurement and recognition of periodic interest cost attributable to a failed sale liability should not be predicated upon, or linked to, the transferor’s recognition of the contractual rate of interest on the related transferred financial asset. However, we recognize that it may be appropriate in certain circumstances to attribute interest cost to a failed sale liability that takes into account the anticipated return on the underlying transferred financial assets, irrespective of their contractual terms. Example TS 5-3 illustrates when this approach may be acceptable.
EXAMPLE TS 5-3
Transfer of an interest in a group of purchased financial assets with credit deterioration accounted for as a secured borrowing
Transfer of an interest in a group of purchased financial assets with credit deterioration accounted for as a secured borrowing
Bad Debt Collector periodically purchases from various originators, at a significant discount, portfolios of unsecured consumer loans that have experienced a more-than-insignificant deterioration in credit quality since origination and are deemed to be PCD. It carries the acquired groups of loans at amortized cost and, in accordance with ASC 310-10-35-53B and ASC 310-10-35-53C, accretes as interest income the non-credit-related discount.
Bad Debt Collector sometimes sells participations (ownership interests) in these portfolios to external investors. Although the interests sold are pari passu and proportionate, the transfers frequently do not satisfy all of the conditions for sale accounting, and thus are reported as secured borrowings on Bad Debt Collector’s balance sheet.
What rate of interest should Bad Debt Collector use to measure the interest expense to attribute to the failed-sale liabilities reported at amortized cost?
Analysis
There is no implementation guidance in ASC 860 that prescribes the rate at which interest should be accreted on the failed-sale liability of PCD assets, and hence determining the accretion rate may require judgment. Different approaches could be used, such as accreting to expected cash flows or (in the case of failed sale of equity securities) an immediate increase of the liability to the current value of the securities.
However, to measure interest expense based on the contractual rate of the underlying loans or based on their effective interest rate (which only includes the non-credit discount/premium) would not be representationally faithful in this case, as the loans are credit impaired (i.e., PCD) when acquired by Bad Debt Collector (unlike the fact pattern in Example TS 5-1).
In any case, Bad Debt Collector should not write down the carrying value of any failed-sale liability prior to extinguishment (final settlement) of the related participation, since doing so would be inconsistent with the liability extinguishment provisions in ASC 405-20-40-1. Such write down would not be appropriate even in instances when Bad Debt Collector increases the allowance for credit losses on the underlying loan pool.- In other words, the accretion rate on the failed sale liability can never be negative.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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