FASB Tightens Rules on QSPEs

An accounting rule often blamed for its role in the mortgage crisis is getting its comeuppance. FASB voted today to tighten rules on qualified special purpose entities.

The rules allowed companies to keep loans off their balance sheets, but the change will require companies to report loans contained in the QSPEs and to increase their capital reserves in proportion as a buffer against potential losses. Regulators say the move will increase transparency.

The recent regulatory stress tests uncovered that the new rule would likely require the 19 largest banks to acknowledge $900 billion in loans and other net assets, according to the Washington Post.

Comptroller of the Currency John C. Dugan has said that banks applied less rigorous underwriting standards on loans sold to investors compared with the loans retained by the banks, the Post reported, setting the stage for investor outrage when banks reported billions of dollars in losses on loans that had been concealed through QSPEs.

While FASB’s decision last month regarding mark-to-market accounting was viewed as giving banks more latitude to boost balance sheets, the new rule moves in the opposite direction by requiring banks to disclose high-risk loans, the Associated Press reported.

On Tuesday, the FASB released this "plain English" explanation of the changes:

The FASB concluded its deliberations of two proposals earlier today which will soon be finalized as standards. One of the proposals relates to the consolidation of variable interest entities, and one will amend existing guidance for when a company “derecognizes” transfers of financial assets. A variable interest entity (VIE) is a business structure that allows an investor to hold a controlling interest in the entity, without that interest translating into possessing enough voting privileges to result in a majority. After considering all of the feedback received on these original proposals exposed for comment in September 2008, the FASB concluded its deliberations and expects to issue final standards in June 2009

Both new standards will require a number of new disclosures.

FIN 46(R) amends existing consolidation guidance for variable interest entities. Variable interest entities generally are thinly-capitalized entities and include many “special-purpose entities”, or “SPEs.” The primary amendment to FIN 46(R) relates to how a company determines if it must consolidate a variable interest entity. Under GAAP, a company must consolidate any entity in which it has a “controlling interest.” The new standard now requires a company to perform a qualitative analysis when determining whether it must consolidate a variable interest entity. Under the standard, if the company has an interest in a variable interest entity that provides it with control over the most significant activities of the entity (and the right to receive benefits or the obligation to absorb losses) the company must consolidate the variable interest entity. Under the new standard, the quantitative analysis often used previously is no longer, by itself, determinative. The newly-approved standard requires ongoing reassessments to determine if a company must consolidate a variable interest entity. This differs from existing guidance, which requires a company to determine if it consolidates a variable interest entity only when specific events occur. Under existing guidance, as expected credit losses increased significantly due to unpredicted market events, some companies did not reconsider whether they should consolidate a variable interest entity. The new standard requires a company to update its consolidation analysis on an ongoing basis.

The new standard requires a company to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A company will be required to disclose how its involvement with a variable interest entity affects the company’s financial statements. For example, if a company consolidates a variable interest entity and the assets of that consolidated entity are restricted, the company must disclose the nature of those restrictions and the carrying amount of such assets. A company will also be required to disclose any significant judgments and assumptions made in determining whether it must consolidate a variable interest entity.

The second standard now headed for finalization -- Statement 140-- enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and a company’s continuing involvement in transferred financial assets. It removes the concept of a qualifying “special-purpose entity” from U.S. GAAP, changes the requirements for derecognizing financial assets, and requires additional disclosures about a transferor’s continuing involvement in transferred financial assets.

A special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk. A company will transfer assets to the SPE for management or use the SPE to finance a large project-- thereby achieving a narrow set of goals without putting the entire firm at risk

Qualifying special-purpose entities (QSPEs) generally are off-balance-sheet entities that are exempt from consolidation. The new standard eliminates that exemption from consolidation. Many qualifying special-purpose entities that currently are off balance sheet will become subject to the revised consolidation guidance in the proposal on consolidations of variable interest entities.

The standard on derecognition restricts when a company may transfer a portion of a financial asset and account for the transferred portion as being sold. Existing guidance permits companies to report many transfers of portions or components of financial assets as sales. Under the new standard, a transfer of a portion of a financial asset may be reported as a sale only when that transferred portion is a pro-rata portion of an entire financial asset, no portion is subordinate to another, and other restrictive criteria are met.

This clarifies the legal isolation requirements to ensure that a company considers all of its involvements and the involvements of its consolidated entities to determine whether a transfer of financial assets may be accounted for as a sale. The newly approved standard also eliminates an exception that currently permits a company to derecognize certain transferred mortgage loans when the company has not surrendered control over those loans.

The new standard requires a company to provide additional disclosures about all of its continuing involvements with transferred financial assets. Continuing involvement can take many forms—for example, recourse or guarantee arrangements, servicing arrangements, and providing certain derivative instruments. The new standard also requires a company to provide expanded disclosures about its continuing involvement until it has no continuing involvement in the transferred financial assets. A company will also need to provide additional information about transaction gains and losses resulting from transfers of financial assets during a reporting period.

Generally, the approved standards will be effective as of the beginning of 2010 and will apply to existing entities, including existing qualifying special purpose entities. However, the amendments on how to account for transfers of financial assets will apply prospectively to transfers occurring on or after the effective date.