A great example of substance over form, FAS 91 can be difficult and error-prone. Common errors include the use of the SLM method instead of the effective-interest method and errors in amortization computations related to the use of prepayment estimates or nonstandard loan types. Below are fice such common mistakes we often make
FAS 91 – we can review this at quarter close .
Many a time managements underestimates the statement’s real-life complexities, thereby under-allocating resources. This is particularly important for lenders who originate a high proportion of ARMs or hybrid loans.
A Vendors software can take care of my FAS 91
Most of us accountants purchase a vendor software to take care of the accounting without verifying whether the vendor software would actually take care of the complex accounting needs of the loan transactions. Management should verify carefully its vendor’s software not only for the correct implementation of the effective-yield method, but also for compliance with Statement no. 91.
The application of Statement no. 91 can be very complicated for bonds with complex cash flows, such as mortgage-backed securities with underlying ARM or hybrid loans, tranches in collateralized mortgage obligations (CMOs), interest-only (IO) strips or principal-only (PO) strips, because past and expected future cash flows of these securities must be considered to compute amortization of the premium or discount.
Blame it on operations!
This is a common practice and poses problems more often than not. In many organizations, it may be the responsibility of the loan-operations department to assign the proper accounting classification of fees in the software. However, without tight controls and close coordination with finance, fees may be categorized improperly by the operations department and receive incorrect accounting treatment.
Prepayment estimates – we will cross the bridge when it comes to it
Several difficulties arise in implementing amortization calculations with prepayment estimates. First, these estimates are allowed only for groups of loans (Statement no. 91, paragraph 19). Second, the amortization calculations are more involved, since an adjustment is necessary every period to correct for errors in prior periods’ prepayment estimates.
Using prepayments has additional implementation challenges since the accounting system must be updated to a prepayment model, and there are many roadblocks in implementing this connectivity correctly.
Incorrect timing in the recognition of fees.
Organizations are at times are under pressure to recognize fees early, rather than defer them, to boost current earnings.
On the contrary many organizations are also under pressure to report low earnings volatility and may be tempted to alter the timing of fee recognition to smooth reported earnings. As FAS 91 can sometimes create earning volatility, managements may be forced to alter the timing of the amortization to make the recognition to be more in line with advance investor forecasts handed over.
A well defined internal controls backed with preventive IT controls can help many a organisations in dealing with a simple accounting treatment.
Saturday, August 30, 2008
EMBEDDED LEASES - ARE YOU AWAKE
Embedded leases are a much loved topic of mine. I have been connected with this term ever since EITF 01-08 was issued in end of 2001. This was followed by pronouncements under IAS as well. The best part which fascinated me towards this topic is that this issue on embedded lease has come to be discussed only after close to three decades of FASB 13 coming into existence.
All GAAP’s (incl. Indian GAAP) in the world describe a lease as an agreement which conveys the right to use property, plant or equipment usually for a stated period of time. (mark the words right to use). Embedded leases are typically embedded in the definition of right to use.
So how does one transliterate the meaning of right to use. The pronouncements (FAS and IAS) both laid down the following guidelines.
1.The arrangement involves the right to use property plant and equipment (PP&E)
2. This PP&E is explicitly identified in the agreement
3. The lease conveys the lessee to use the specified PP&E at all times.
To explain the GAAP rules, lets discuss an embedded lease example.
Company A is in the business of manufacturing specialized products. A major (say 90%) of the finished good is outsourced by the Company to various vendors. The terms of the agreement Company A, has with the vendors are the following
1. Term of agreement are for a period of 5 years (non cancelable by the vendor);
2. Vendor’s production methodology is to be on the guidelines as laid Company A;
3. Vendor is to enter into an exclusive production contract with the Company;
4. All produce from the Vendor is to be sold exclusively;
5. Minimum guarantee given by Company A for production by the vendor;
6. Company A has the right to inspection of the PP&E at all times
7. Vendor charges on a cost plus mark up model (costs include all labour, overheads and raw Material costs, interest etc) on the basis of the planned production and guarantee.
The contract by a first reading may give reason to believe that it is a outsourcing contract for manufacture of goods & the moneys to be paid by Company A to the vendor would typically go into a cost of goods sold account in the P&L, but if were to scan thru this agreement, there is an embedded lease element.
1. The above agreement gives the Company the right to use all the PP&E of the vendor (incl machines/real estate)
2. The vendors return on equity in the project has been guaranteed by Company A on the basis of the Cost + mark up model
3. The PP&E is for exclusive use by Company A for a period of 5 years.
Now that we have identified that the agreement has an element of lease, our next step is to identify the classification of this lease. This can be done in three simple steps
Split the cost of the vendor into three
capex recoveries (depreciation/interest) ;
opex costs (labour, overheads).
Mark up (return of equity which the vendor expects on his efforts)
This data should be normally available when Companies tie up exclusively with vendors, as all price negotiations calculations will lead to cost plus mark up model.
Analogize the capex costs to minimum lease payments (MLP) while retaining the opex costs and mark ups as cost of goods sold
Now that we have the MLP’s (capex costs) , we can apply the rules of FAS 13 in determining the classification of this lease.
Impact of embedded leases on financials
Most of the embedded leases result in the classification of a substantial portion of the contract as a finance lease
Lets put down numbers on the above illustration (for a year of operations) 
Total price charged by the vendor (vendor) is Rs. 100 (opex 50+capex+30+markup 20). If this agreement were to be classified as finance lease then the financials will look like this
Though the above P&L is neutral on PAT terms, but there is a significant difference in the EBITDA numbers and the balance sheet numbers, as well as the turnover for the lessor which are very important financial gauge for a lot of Companies with their investors. (in this case the vendor).
Other examples where one could potentially unearth an embedded lease could be in the ITES and BPO sectors. Most of these agreements are structured on a cost+ mark up model with a clause on exclusivity (mainly to protect commercial interests)
With larger agreements, you can also view these contracts to be a bigger part of consolidation when you apply FIN 46. Now that’s an another substance over form issue aint it.
IFRS Road map - EY comments
Aug 29, Statement by Jim Turley CEO of Ernst & Young.
With the world converging to the IFRS, E&Y (BIG4) issued a press release on the firms strategy towards moving and creating bandwidth for IFRS.
Excerpts of the statements are below;
"Today the U.S. Securities and Exchange Commission took its most significant step toward the adoption of a single set of high quality global accounting and financial reporting standards that everyone can use. The dominant language of financial reporting worldwide is fast becoming IFRS and we applaud the Commission for approving for public comment a proposed "Roadmap." Notwithstanding the strength and size of the U.S. capital market, we cannot afford to be left behind.
In today's connected global economy, it's vital we all speak the same "language." More than 100 countries require, permit or base their standards on IFRS and the number is increasing. Disparate accounting standards benefit no one. A common set of high quality standards provides a foundation for capital market activity that promotes investment and strengthens economies. A change to a common global accounting language will also benefit investors and market efficiency by increasing the transparency and comparability of information.
While there will be many challenges associated with conversion to IFRS, a U.S. shift to the global standard will provide continuous benefit. With respect to this matter, we believe that with today's action by the SEC, the U.S. -- like the rest of the world -- is on the right path. "
The move to International Financial Reporting Standards (IFRS) is the single most important initiative in the financial reporting world, the impact of which stretches far beyond accounting to affect every key decision you make, not just how you report it.
Now with the world community moving towards a single GAAP. We will be seeing a lot more matured and sound accounting practices coming to the fore. This single biggest benefit which i see is that we will have a whole pool of talented accountants converging and deliberating on a single GAAP. This is substance over form right.
With the world converging to the IFRS, E&Y (BIG4) issued a press release on the firms strategy towards moving and creating bandwidth for IFRS.
Excerpts of the statements are below;
"Today the U.S. Securities and Exchange Commission took its most significant step toward the adoption of a single set of high quality global accounting and financial reporting standards that everyone can use. The dominant language of financial reporting worldwide is fast becoming IFRS and we applaud the Commission for approving for public comment a proposed "Roadmap." Notwithstanding the strength and size of the U.S. capital market, we cannot afford to be left behind.
In today's connected global economy, it's vital we all speak the same "language." More than 100 countries require, permit or base their standards on IFRS and the number is increasing. Disparate accounting standards benefit no one. A common set of high quality standards provides a foundation for capital market activity that promotes investment and strengthens economies. A change to a common global accounting language will also benefit investors and market efficiency by increasing the transparency and comparability of information.
While there will be many challenges associated with conversion to IFRS, a U.S. shift to the global standard will provide continuous benefit. With respect to this matter, we believe that with today's action by the SEC, the U.S. -- like the rest of the world -- is on the right path. "
The move to International Financial Reporting Standards (IFRS) is the single most important initiative in the financial reporting world, the impact of which stretches far beyond accounting to affect every key decision you make, not just how you report it.
Now with the world community moving towards a single GAAP. We will be seeing a lot more matured and sound accounting practices coming to the fore. This single biggest benefit which i see is that we will have a whole pool of talented accountants converging and deliberating on a single GAAP. This is substance over form right.
Tuesday, August 26, 2008
Business Combinations Topic Released Onto FASB Codification
The Financial Accounting Standards Board has released the Business Combinations Topic to the FASB Accounting Standards Codification. Now in its verification phase, the Codification simplifies the organization of thousands of authoritative U.S. accounting pronouncements issued by multiple standard setters.
"The addition of the Business Combinations Topic is yet another step in the evolution of the Codification, which, when approved in April 2009, will become the single source of authoritative U.S. GAAP," said Tom Hoey, project director for the FASB Codification project. "During the current verification period, constituents are encouraged to provide their input on whether the Business Combinations Topic and all other Codification content accurately reflect U.S. GAAP."
Users who register at http://asc.fasb.org/ are able to access and review the online Codification, including the newly added Business Combinations Topic, free of charge.
The Codification's one-year verification phase, which ends Jan. 15, 2009, gives constituents the chance to become acquainted with the Codification's new structure and provide FASB with feedback regarding any content issues before it becomes authoritative.
The Business Combinations Topic integrates various standards, including FASB Statement No. 141(R) Business Combinations; FASB Statement No. 109, Accounting for Income Taxes; FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109; and various EITF Issues and SEC Staff Accounting Bulletins. The FASB decided to include only the post-141(R) standards in the Business Combinations Topic.
Users are advised that the Codification content is not yet approved as authoritative and, therefore, they must verify research results using their existing resources for the currently effective literature. In April 2009, the FASB expects to approve the Codification content -- excluding related SEC content -- as the single authoritative source of U.S. accounting and reporting standards.
The Codification does not include governmental accounting standards.
Securitization vs assignment of receivables
Case: Whether securitisation rules of the Reserve Bank of India should be applied to sale/assignment of receivables.
My analysis.
Para 2 of the RBI - Securitisation is a process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in return for an immediate cash payment. The cash flow from the underlying pool of assets is used to service the securities issued by the SPV. Securitisation thus follows a two-stage process. In the first stage there is sale of single asset or pooling and sale of pool of assets to a 'bankruptcy remote' special purpose vehicle (SPV) in return for an immediate cash payment and in the second stage repackaging and selling the security interests representing claims on incoming cash flows from the asset or pool of assets to third party investors by issuance of tradable debt securities.
By virtue of this definition, RBI does not intend to rope in pure sale of financial receivables between two parties at arms length price. I view this guidelines a measure to regulate SPV' and more importantly protect investors interests who subscribe to PTC's issued on the security of the pool of receivables to third party investors.
Guidelines on regulating SPV's, the Securitisation Act are all in the mode of continuous evolution as can be seen by the frequent changes/notifications on the Acts relating to SPV's. As the process also involves issuing of PTC's to third parties, there is a fiduciary responsibility of the RBI to closely protect the investors interests. A reading through Para 7 and Para 8 of the guidelines throws light on the RBI's fiduciary responsibility on insulating and minimizing financial risks to parties involved to complete a securitisation transaction.
These stiffer guidelines are akin to the differentiation which RBI maintains for NBFC's accepting public deposits and those that do not. NBFC's accepting public deposits are closely monitored and have stringent regulations than those who do not as public money is involved and it is RBI's responsibility to ensure there is no financial loss to public depositors.
A similarity in the nature of the transactions between securitisation and assignment should not be driving the accounting and measurement principles. The true sale criteria is to be viewed as a brightline to test the rights and obligation assertion while drawing up the financial statements.
True sale is also more of a substance over form issue and should not be restricted to guidelines laid by the RBI (in para 7) as these maynot be exhaustive. For eg. RBI's guidelines have no reference to synthetic securitizations or Tier II level securitizations, but intrue sense these will be need to be covered. Securitisation transactions are in the nascent stage in India and are not as maturedas US markets. We can definitely see more circulars over the next fewyears, when markets become more and more innovative and matured.
Differentiation between assignment and securitisation as per RBI is clearly laid GAAP practice in India also has a differentiation in the accounting treatment. Also refer ICICI's accounting policies Draft Accounting standard AS 30 of ICAI (issued after RBI's circular)clearly lays down profits to be recognized upfront upon sale of financial assets and there is no reference to securitisation (as there is a guidance note to that effect) already issued.Assuming Company X were to sell its entire balance sheet (which comprises 99% of loans), in an outright buy over, would the position be the same that you will require Company X to defer its profits as per securitisation norms.
Open thoughts:
This is a para to which i have been grappling with and am unclear on the purpose of the para of the Reserve Bank of India.
Para 11.11 Any utilization / draw down of the credit enhancement should be immediately written-off by debit to the profit and loss account.Should it be construed that for transactions in the nature of securitisations, we should not be providing for collections losses upfront at the time of securitisation as laid down by ICAI's guidance note and should record the loss on an "actual" basis. Go ahead and crack this question on the Catch 22 phrase
The opinions expressed above are solely mine and are not to be construed to be thrust upon others. Views and feedback are invited.
My analysis.
Para 2 of the RBI - Securitisation is a process by which assets are sold to a bankruptcy remote special purpose vehicle (SPV) in return for an immediate cash payment. The cash flow from the underlying pool of assets is used to service the securities issued by the SPV. Securitisation thus follows a two-stage process. In the first stage there is sale of single asset or pooling and sale of pool of assets to a 'bankruptcy remote' special purpose vehicle (SPV) in return for an immediate cash payment and in the second stage repackaging and selling the security interests representing claims on incoming cash flows from the asset or pool of assets to third party investors by issuance of tradable debt securities.
By virtue of this definition, RBI does not intend to rope in pure sale of financial receivables between two parties at arms length price. I view this guidelines a measure to regulate SPV' and more importantly protect investors interests who subscribe to PTC's issued on the security of the pool of receivables to third party investors.
Guidelines on regulating SPV's, the Securitisation Act are all in the mode of continuous evolution as can be seen by the frequent changes/notifications on the Acts relating to SPV's. As the process also involves issuing of PTC's to third parties, there is a fiduciary responsibility of the RBI to closely protect the investors interests. A reading through Para 7 and Para 8 of the guidelines throws light on the RBI's fiduciary responsibility on insulating and minimizing financial risks to parties involved to complete a securitisation transaction.
These stiffer guidelines are akin to the differentiation which RBI maintains for NBFC's accepting public deposits and those that do not. NBFC's accepting public deposits are closely monitored and have stringent regulations than those who do not as public money is involved and it is RBI's responsibility to ensure there is no financial loss to public depositors.
A similarity in the nature of the transactions between securitisation and assignment should not be driving the accounting and measurement principles. The true sale criteria is to be viewed as a brightline to test the rights and obligation assertion while drawing up the financial statements.
True sale is also more of a substance over form issue and should not be restricted to guidelines laid by the RBI (in para 7) as these maynot be exhaustive. For eg. RBI's guidelines have no reference to synthetic securitizations or Tier II level securitizations, but intrue sense these will be need to be covered. Securitisation transactions are in the nascent stage in India and are not as maturedas US markets. We can definitely see more circulars over the next fewyears, when markets become more and more innovative and matured.
Differentiation between assignment and securitisation as per RBI is clearly laid GAAP practice in India also has a differentiation in the accounting treatment. Also refer ICICI's accounting policies Draft Accounting standard AS 30 of ICAI (issued after RBI's circular)clearly lays down profits to be recognized upfront upon sale of financial assets and there is no reference to securitisation (as there is a guidance note to that effect) already issued.Assuming Company X were to sell its entire balance sheet (which comprises 99% of loans), in an outright buy over, would the position be the same that you will require Company X to defer its profits as per securitisation norms.
Open thoughts:
This is a para to which i have been grappling with and am unclear on the purpose of the para of the Reserve Bank of India.
Para 11.11 Any utilization / draw down of the credit enhancement should be immediately written-off by debit to the profit and loss account.Should it be construed that for transactions in the nature of securitisations, we should not be providing for collections losses upfront at the time of securitisation as laid down by ICAI's guidance note and should record the loss on an "actual" basis. Go ahead and crack this question on the Catch 22 phrase
The opinions expressed above are solely mine and are not to be construed to be thrust upon others. Views and feedback are invited.
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