What publications make the "top 10" reading list of bank chief executives and chief financial officers. While the selections vary from executive to executive, it's safe to assume that exposure drafts of proposed statement of financial accounting standards are never included.
Or is never too strong a word? What if the proposed changes in accounting practices mean that your bank will exceed its legal lending limit because a loan participation agreement no longer qualifies as a sale? What if they could change how you structure repurchase agreements or the structuring alternatives and cost of capital in your credit card or automobile securitizations as sales instead of financings?
These examples are not all inclusive, but they illustrate why bank chief executives and chief financial officers should carefully follow the Financial Accounting Standards Board's proposed standard Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which has key business implications for many of these banking transactions. A clear understanding of the potential impact of this statement is essential if bank management is making the changes in business strategy that will be required if the statement is enacted as drafted.
Most business people agree that accounting shouldn't drive the structure of an economic transaction. However, this proposal may have exactly that result.
Important Considerations
The board's objective in this exposure draft is to develop consistent accounting standards for securitizations and other financial transactions, including determining when financial assets should be considered sold and removed from the balance sheet. Under the approach chosen by the board, an institution would be required to recognize financial assets it controls and to derecognize (remove from the balance sheet) assets when it relinquishes control.
The board attempted to address practicality concerns by designing the "assuredly temporary" exception for short-term repurchase agreements, or "repos," and securities lending transactions. The exposure draft defines a term of greater than 90 days as not being "assuredly temporary."
Despite the board's efforts, many industry participants believe that transactions with a longer maturity term should not be treated as sales because to do so ignores the fact that these transactions are financings. The arbitrary 90-day cut-off will result in very different accounting treatment for transactions that are identical in every respect except duration, which could be as little as one day.
Furthermore, opponents to this approach believe that the board's definition of "control" is not appropriate for repo transactions, where there is a clear contractual obligation to return the securities in the future.
They believe that in repo and securities lending transactions, control is not surrendered because these transactions are generally entered into for financing purposes.
Gross-Up Effect
Critics of the FASB approach say the current treatment for the repos and securities lending transactions is appropriate and correctly reflects the economic substance of these transactions. They argue that the current accounting treatment clearly reflects, on the balance sheet, the asset or liability incurred as a result of entering into a repo or securities lending transaction.
Under the proposed accounting treatment, repo and securities lending transactions will result in the double-counting of assets on the books of both the borrower and the leader.
In addition, many disagree with the board's conclusion that loan participation agreements which prohibit participants from selling or pledging their participants should not be accounted for as sales. Under the exposure draft, the lead bank cannot remove certain participated loan balances from its balance sheet, and the participant will record a receivable from the lead bank on its balance sheet.
As such, the exposure draft rule would gross-up the lead bank's balance sheet, impacting legal limits, debt ratios, and capital ratios. Opponents believe that the transferability of the purchased interest should not determine the seller's accounting.
Regulatory Considerations
Regulators will need to evaluate how the proposed changes on repurchase agreements, securities lending, and loan participations will affect call report instructions and risk-based capital requirements.
For example, the Call Report Glossary contains a general rule that repurchase and resale agreements are to be reported as borrowings and loans, respectively. Securities sold under agreements to repurchase at maturity in one business day (or those under a continuing contract) are reported as federal funds purchased. Those that mature in more than one business day are reported as securities sold under agreements to repurchase.
The banking agencies currently measure a bank's adherence to legal lending limits using on-balance-sheet loan amounts under generally accepted accounting principles. As noted earlier, if certain loan participations must remain on the lead bank's balance sheet, the lead bank could quickly reach its limits.
While a loan participation agreement may restrict the participant's ability to sell or repledge the participation, the participant still must absorb all losses on the loan participation and cannot pass credit risk back to the lead bank. However, it is uncertain how the agencies will react to this proposed change in GAAP.
Financial institutions and other issuers will need to identify all transactions that could potentially be affected by the statement, examine operational, tax, systems, capital, balance sheet structure,and other business issues, and research new financing structures to meet customer needs.
Mr. Ward is national director and Mr. Brezovec national director of accounting of the financial services practice of Ernst & Young, New York.
