July 28, 2000; Volume 7; Issue 8

The ABCs of ABS:

H
ow does an investor account for an asset-backed security
(ABS)? It’s a trick question. Until now there’s been no
Accounting for comprehensive accounting guidance covering the basics:
Asset-Backed Securities recording interest income and recording losses for other-than-
temporary impairments. At July’s meeting, the EITF stepped up to
the plate (Issue 99-20) and reached a consensus covering many – not all
– instruments.

What makes these basic issues so tough for an ABS is that many asset-
backed securities feature terms that make the timing and amount of
future cash flows uncertain.1 Until these factors are pinned down
(usually at or close to maturity), the best an investor can do is estimate
the yield he or she is currently earning on the investment. Also, changes
in estimated cash flows and changes in prevailing market conditions
affect the value of the ABS.

The Task Force decided that investors in asset-backed securities (at least
those covered by Issue 99-20) should record changes in their estimated
yield using the prospective method. That’s good news for investors.
Compared to one alternative (the retrospective method), the effect of
changes in estimated cash flows doesn’t get concentrated in a single
accounting period. Instead, the investor recognizes the effect over the
remaining life of the ABS.

1
Two sets of factors make the timing and amount of cash flows uncertain. First,
the assets underlying the deal often bear credit risk and/or can be prepaid before
their scheduled maturity. Second, a securitization vehicle typically allocates the
cash flows (according to a predetermined formula) differently to various
tranches of securities it issues. For example, tranching allows an investor in a
subordinated certificate to bear the brunt of the credit risk of the securitized
assets in exchange for a higher rate of interest.

As developments warrant, Heads Up is edited by Jim Johnson and published by Deloitte & Touche’s
Capital Markets Group (New York). Heads Up contains general information only; it is not a substitute for
consultation with a professional. To receive copies, contact Robert Canaan at rcanaan@dttus.com or visit
our website at www.dttus.com (Publications).

Staying Alive!
EITF Nears a Consensus on
Equity Derivative Accounting
July 28, 2000
With every silver lining there is, of course, a cloud. If the carrying
amount of the ABS exceeds its current fair value, the investor must
determine if the excess represents an other-than-temporary decline in
value. Generally, any decrease in current estimated cash flows
(timing and amount) compared to the investor’s previous estimate,
points to an other-than-temporary impairment. The investor records the
excess carrying amount as a loss in the income statement. We expect
that the Issue 99-20 approach will lead to earlier and/or more frequent
loss recognition.
The EITF wants the consensus applied no later than fiscal quarters
beginning after December 15, 2000, without restatement of earlier
financial statements. See Attachment I for additional details, including a
discussion of which asset-backed securities are included in the scope of
the issue.
__________________________________________________________
L
ike the last remaining contestant on Survivor, carefully crafted
derivative contracts linked to a company’s own stock should
prevail against ongoing accounting challenges – that is, if the
EITF’s tentative July consensus on Issue 00-19 holds. Among other
requirements, the tentative consensus requires a cap on the number of
shares (if any) that can be issued and the contract cannot require the
delivery of registered shares.
To appreciate the issue, a little background is in order. Fundamentally,
the question is whether the derivative is marked to fair value via income
(because it is accounted for as an asset or liability) or not (because it is
accounted for as equity or temporary equity). The EITF established the
framework for answering the question when it deliberated Issue 96-13
(Heads Up, November 16, 1996). The framework rests on the method by
which the derivative can be settled. Net share settlement and physical
settlement jibe with equity (or temporary equity) treatment. 2 Thus,
contracts that require either of these settlement mechanisms or give the
company the option to choose one of these methods are not marked to
fair value.
In Issue 00-7 (Heads Up, March 16, 2000), the EITF focused on
settlement provisions triggered by a specific event such as the company’s
bankruptcy. According to the consensus, a derivative that includes any
provision (triggered by an event beyond the company’s control) that
requires net cash settlement will result in asset or liability accounting
2
You’ll need a glossary (at the very least) to decipher this issue:
• Physical Settlement – The buyer of the shares delivers the stated amount of
cash to the seller of the shares who delivers the stated number of shares.
• Net Share Settlement – The party with a loss delivers shares with a current
fair value equal to the other party’s gain.
• Net Cash Settlement – The party with a loss delivers cash equal to the other
party’s gain.
Page 2
 for the contract. Tautologically speaking, “any” means any. In other
words, the company cannot avoid asset/liability accounting because it
decides the triggering event is unlikely to occur.

As companies and their advisors reviewed existing contracts for

compliance with Issue 00-7, they identified a number of specific contract
terms or legal and regulatory impediments that could preclude a
settlement method consistent with equity (or temporary equity)
accounting. The Task Force reached a tentative consensus that equity-
linked derivatives must feature six conditions to be accounted for as an
equity (or temporary equity) instrument under Issue 96-13’s framework.
See Attachment 2 for a list of the conditions and a brief explanation of
their significance.

Apply the requirements of Issue 00-19 (and 00-7) to contracts entered

into after the date on which the Task Force reaches a final consensus
(we’re guessing this will be the date of the September meeting). For
contracts that predate a final consensus,3 the accounting requirements of
Issue 00-19 should be applied as of June 30, 2001 – giving companies
time to fix non-compliant positions.

The EITF also reached conclusions on derivatives indexed to a

subsidiary’s stock. Issue 00-6 deals with the parent company’s
accounting for a derivative it enters that is indexed to the stock of one of
its consolidated subsidiaries. Generally, these contracts will be
accounted for as derivatives under FAS 133 and marked to fair value via
earnings. (Any ultimate share settlement, if it occurs, affects the
accounting for the investment.) If the contract is excluded from the
scope of FAS 133, it is accounted for as follows:

• A firmly committed contract to buy or sell shares of a subsidiary

should be accounted for as a purchase or a sale on the date the
forward contract settles.

• The forward purchase or sale price should be considered in

determining (or adjusting) an impairment loss on the investment in
the subsidiary.

When are these derivatives excluded from the scope of FAS 133? Here’s
an example: (1) the derivative requires physical settlement, (2) the
subsidiary’s shares are not readily convertible to cash, and (3) no other
market mechanism facilitates net settlement of the contract. But don’t
rely on the FAS 133 exclusion applicable to some equity derivatives (see
paragraph 11(a)). The EITF decided that the paragraph 11(a) exclusion
applies only to parent company contracts linked to the parent’s shares
(for consolidated financial statements).

3
Considering a new contract that predates a final consensus? Prudence is the
better part of valor – check with your accountants if its terms deviate from the
conditions outlined in Attachment 2.

July 28, 2000 Page 3

 Issue 00-6 remains on the agenda pending a discussion of written
options indexed to a subsidiary’s shares.

Issue 00-4 deals with a narrower fact pattern: – the derivative is between
a parent company and a minority shareholder in one of the parent’s
subsidiaries. The derivative’s underlying is the minority holder’s shares.
The derivative is a fixed price forward purchase contract, a combination
of calls and puts with similar terms or a total return swap.

The Task Force concluded that the parent company retains the risks
and rewards of owning the minority interest. The derivative should
be combined with the minority interest and accounted for as a financing.
The EITF plans no further discussions.
__________________________________________________________

Working Together:
The FDIC Issues a
Final Rule on
J ust issued is the FDIC’s final rule (effective September 11)
covering securitizations. What’s the big deal? When FASB’s
proposed amendment to FAS 125 takes effect, FDIC insured
institutions will first be subject to a key FAS 125 requirement. The
Asset Securitizations FDIC’s final rule is designed to give banks, their lawyers and their
auditors the basis for concluding that properly structured
securitizations isolate the transferred assets in the event that the selling
bank fails (Heads Up, September 9, 1999). FASB is targeting an end-of-
August publication date for the amendment. We found the rule at the
FDIC’s website; try this address:

www.fdic.gov/regulations/laws/federal/00TreatFA.html
.__________________________________________________________

Answers Even Regis Doesn’t

Know! The Firm’s Latest
Edition of FAS 133 Q&As
S tumped over the complex provisions of FAS 133? Help is on
the way. Contact Robert Canaan (rcanaan@dttus.com) and
he’ll put the Firm’s latest guidance on FAS 133 in your hands.
The publication asks and answers 98 implementation questions ranging
from the basic to the arcane and – for those with the appropriate
appetite – includes sample journal entries illustrating the fine points.
_________________________________________________________

Trash Those Binders!

Back Issues of “Heads Up”
Available Online
W ell, don’t trash everything. On D&T’s website, we’ve
archived back issues of Heads Up, dating from April 1998.
Go to www.us.deloitte.com, click on “Publications” and
look for the Heads Up button in the left margin.

July 28, 2000 Page 4

 Attachment 1
Questions and Answers
EITF 99-20, Recognition of Interest Income
and Impairment on Certain Investments

Need a little more guidance? In this attachment, we address the following questions:

1. Are all asset-backed securities included within the scope of EITF Issue 99-20?

2. How about an example of the Prospective Interest Method?

3. What accounting guidance does Issue 99-20 affect?

4. Do the impairment requirements of 99-20 mean that I carry asset-backed securities at the “lower of cost or
market”?

5. I’m a seller, not a buyer. Does 99-20 apply to me if I securitize loans that I originate?

6. RegionsBanc owns a “vanilla” LIBOR-indexed ABS for which it paid a significant premium. The
underlying assets cannot be prepaid. Does RegionsBanc face any special considerations regarding
impairments?

7. Does Issue 99-20 offer any guidance on estimating future cash flows?

8. I account for all of my ABS investments in a trading account at fair value. Does 99-20 affect me?

9. In transition, how do I account for an existing ABS?

Here are the answers:

1. Are all asset-backed securities included within the scope of EITF Issue 99-20?

No. While the guidance applies to many asset-backed securities, billions-worth are excluded (most agency and
AAA-rated non-agency paper, for example). By the way, when you read the formal EITF minutes, you’ll find
that the FASB staff uses the more technically accurate term beneficial interest in a securitization versus our
vernacular use of the term asset-backed security. However, unless an asset-backed security appears in the
table below, Issue 99-20 covers it.

Excluded ABS Comments

1 High credit quality asset-backed
securities not subject to paragraph
14 of FAS 125 (see exclusion 2)
Factors that could qualify an ABS as one of high credit quality:
• Guarantees of the U.S. government and its agencies
• Guarantees of high-quality monoline insurers
• The presence of collateral that makes losses remote
• Credit enhancement in the form of subordinated interests
 Excluded ABS
2 Asset-backed securities not
accounted for as a debt security
under FAS 115 or FAS 125,
paragraph 14
Comments
FAS 115 explicitly covers all instruments that are debt securities
or marketable equity securities. While most ABS take the form of
a debt security (and thus do not meet exclusion 2), some interests
take the form of equity (e.g. a non-certificated residual interest).
The Task Force observed that many non-debt interests are
nonetheless accounted for as debt instruments under FAS 115 and
therefore are not eligible for scope exclusion 2.

Paragraph 14 of FAS 125 requires certain instruments to be

accounted for like an FAS 115 available for sale or trading
security. 4 Thus, even a high quality ABS is included in the scope
of Issue 99-20 if it is covered by paragraph 14.
3 An ABS that results in The investor accounts for the underlying assets in the consolidated
consolidation by the investor of the financial statements using applicable, generally accepted
entity issuing the ABS accounting principles.
4 An ABS within the scope of PB 6 applies to loans and debt securities purchased at a discount
AICPA Practice Bulletin 6, when it is probable that estimated undiscounted future cash flows
Amortization of Discounts on will not cover stated principal and contractual interest.
Certain Acquired Loans
5 Securities backed by assets that do Assets that do not feature contractual cash flows include common
not feature contractual cash flows stock equity securities and certain option-based derivatives.
due to the holder

Example 1. Insurance Co. purchases two securities backed by mortgages guaranteed by the US government.
It pays par for the first security. It pays 115% of par for the second security (we exaggerated the premium on
purpose) because the instrument has appreciated in value since it was issued. Only the first of the two
securities is excluded from the scope of Issue 99-20. Why? The second security exposes Insurance Co. to loss
from prepayments, a circumstance covered by paragraph 14 of FAS 125.

2. How about an example of the Prospective Interest Method?

Example 2. TechForever pays $231,450 for a security backed by high quality, short-term prepayable loans.
The security entitles TechForever to all of the interest and none of the principal payments on the underlying
pool of loans. TechForever must apply the provisions of Issue 99-20 because the ABS is subject to paragraph
14 of FAS 125.

4
Paragraph 14 states the following:

Interest-only strips, loans, other receivables, or retained interests in securitizations that can contractually be prepaid or
otherwise settled in such a way that the holder would not recover substantially all of its recorded investment shall be
subsequently measured like investments in debt securities classified as available-for-sale or trading under Statement 115,
as amended by this Statement.

Attachment 1 Page 2
 When TechForever made its initial investment, it forecasted the expected cash flows and discounted them at a
market rate commensurate with the prepayment and credit risks of the investment. The initial evaluation
indicates that TechForever will earn an all-in yield of 15% based on the following cash flows:

Total
Yr. Cash Flows
1 $100,000
2 83,625
3 65,613
4 45,799
5 24,004
$319,041

At the end of year 1,5 the investment has generated $100,000 – exactly equal to the original forecast. How
much is interest income? $34,718 – equal to the forecasted yield times the carrying amount of the asset (15%
X’s $231,450). The balance of the cash received represents TechForever’s recovery of its investment or
$65,282 ($100,000 - $34,718).

At the beginning of year 2, TechForever estimates future remaining cash flows and concludes that the timing
and amount remain unchanged from its initial estimate. In year 2, TechForever recognizes $24,925 of interest
income. That’s equal to the unchanged yield of 15% times the adjusted carrying amount6 of $166,168. The
remainder of year 2’s cash flow ($58,700) reduces TechForever’s carrying amount.

At the end of year two, here’s where TechForever stands:

Amortized Cost
Net
Period Beginning Change End Interest Total Cash Proof

1 231,450 65,282 166,168 34,718 100,000 15%

2 166,168 58,700 107,468 24,925 83,625 15%

During Period 3, TechForever determines that some of the loans underlying the securitized asset pool have
prepaid. It revises its earlier cash flows as follows:

Total Cash Flows

Yr. Original Revised
1 $100,000 $100,000
2 83,625 83,625
3 65,613 64,300
4 45,799 44,883
5 24,004 23,524
$319,041 $316,332

5
In reality, investors will make this evaluation at least quarterly.
6
The initial carrying amount of the investment is its fair value (if purchased) or the allocated basis (if retained in a
securitization – see question 4). Subsequently, the carrying amount is the sum of (a) the initial investment less (b) cash
received to date less (c) other-than-temporary impairments recognized to date…plus (d) the yield accreted to date.

Attachment 1 Page 3
 The internal rate of return of an investment that costs $107,468, generating the forecasted cash flows from
years three to five, is approximately 13.57%. Beginning in year 3 (assuming the absence of an other-than-
temporary impairment – see below), TechForever uses the revised yield to recognize interest income. The
Table below displays the results.

Amortized Cost

Period Beginning Net Change End Interest Total Cash Proof

3 107,468 49,712 57,755 14,588 64,300 13.57%
4 57,755 37,043 20,712 7,840 44,883 13.57%
5 20,712 20,712 0 2,812 23,524 13.57%

Does TechForever recognize an other-than-temporary impairment at the end of period 2? The answer
depends on the fair value of the interest only strip. If market participants require less than a 13.57% return,
the fair value of the investment will be more than TechForever’s carrying amount. TechForever would not
record an other-than-temporary impairment even though its estimate of future cash flows (timing and amount)
has decreased. But if the market yield on the investment was more than 13.57% (meaning that the fair value of
the investment was less than the carrying amount), TechForever would record an other-than-temporary
impairment by permanently writing down the asset. The future yield would be based on the rate necessary to
make the present value of the forecasted cash flows equal the current fair value (the written down amount) of
the interest-only strip.

3. What accounting guidance does Issue 99-20 affect?

Issue 99-20 trumps the following EITF Issues:

• 89-4, Accounting for a Purchased Investment in a Collateralized Mortgage Obligation Instrument or in a

Mortgage-Backed Interest-Only Certificate

• 93-18, Recognition of Impairment for an Investment in a Collateralized Mortgage Obligation Instrument

or in a Mortgage-Backed Interest-Only Certificate.

First, Issue 99-20 dramatically affects impairment accounting when compared to the method required by
Issue 93-18. Under both methods, an other-than-temporary impairment causes the investor to write down the
ABS to fair value. But the circumstances that trigger the adjustment differ. Under EITF 93-18, the investor
discounts estimated future cash flows at a risk-free rate. An impairment adjustment is triggered when the
present value of the cash flows is less than the investor’s carrying amount. Under 99-20, any decrease in the
estimated future cash flows (timing and amount)7 triggers the write down when the fair value of the security is
less than the investor’s carrying amount.

Example 3. Finance-It-All owns an ABS. At 6/30/0X, the following amounts pertain to the investment:

At 6/30/0X
1 Carrying Amount $1,100,000
2 Fair Value 1,000,000
3 Present Value of Future Cash
Flows Using a Risk-Free Rate $1,150,000

7
Exclude decreases due solely to interest-rate resets on plain vanilla floating rate ABS. See Question 6.

Attachment 1 Page 4
 Assuming a decrease in estimated cash flows, Issue 99-20 requires Finance-It-All to write down the ABS to
$1,000,000. Under Issue 96-13, Finance-It-All avoids a write down because the present value of the future
cash flows, discounted at a risk-free rate, exceed the ABS’s carrying amount.

Second, Issue 99-20 casts a wider net than the EITF issues cited above – it applies to securities (within its
scope) backed by all forms of asset classes, not just mortgages.

4. Do the impairment requirements of 99-20 mean that I carry asset-backed securities at the “lower of cost
or market”?

No. First of all, not all asset-backed securities are within the scope of EITF 99-20 (see question 1). For
example, high credit, quality asset-backed securities (unless recorded at a significant premium) are outside the
issue’s scope. Second, the impairment test involves two triggers: a decline in fair value below the investor’s
carrying amount and a decrease in estimated future cash flows. Having said that, the impairment test is more
rigorous than those included in current GAAP and will lead to more impairment adjustments.

5. I’m a seller, not a buyer. Does 99-20 apply to me if I securitize loans that I originate?

Usually. Issue 99-20 generally applies to securitizers who retain most or a portion of the cash flows on the
securitized assets that are accounted for as debt securities. To make the initial evaluation of yield, use the
carrying amount of the asset-backed security (it usually differs from fair value). A securitizer determines the
initial carrying amount by allocating the original carrying amount of the securitized assets to the portion sold
and the portion retained based on the relative fair value of each. For an example, download Securitization
Accounting under FAS 125 at D&T’s website (www.us.deloitte.com) and click on Publications.

6. RegionsBanc owns a “vanilla” LIBOR-indexed ABS for which it paid a significant premium. Does
RegionsBanc face any special considerations regarding impairments?

Yes. First, note that this is an unusual fact pattern. Often, a vanilla variable-rate ABS will trade at or near its
par amount. But assume that RegionsBanc paid a premium because it acquired the ABS in the secondary
market and the credit quality of the underlying assets has significantly improved since the issuance date of the
security.

Further assume that since RegionsBanc’s purchase, the fair value of the ABS has declined below the bank’s
carrying amount. Further investigation indicates that RegionsBanc’s forecasted cash flows have declined only
because the forward LIBOR curve indicates that it will receive less interest than previously forecast.
RegionsBanc does not face an other-than-temporary impairment. According to Issue 99-20:

Absent any other factors that indicate an other-than-temporary impairment has occurred, changes in the
interest rate of a “plain-vanilla,” variable-rate beneficial interest generally should not result in the
recognition of an other-than-temporary impairment (a plain-vanilla, variable-rate beneficial interest
does not include those variable-rate beneficial interests with interest rate reset formulas that involve
either leverage or an inverse floater).

Attachment 1 Page 5
 7. Does Issue 99-20 offer any guidance on estimating future cash flows?

Yes. At the acquisition or securitization date, future cash flows are the holder’s estimate of the following,
respectively:

1. The amount and timing of estimated future principal and interest cash flows used in determining the
purchase price, or

2. The holder’s fair value determination for purposes of determining a gain or loss under Statement 125.

In subsequent periods, estimated cash flows are the holder’s estimate of the amount and timing of estimated
principal and interest cash flows based on the holder’s best estimate of current information and events
that a market participant would use in determining the current fair value of the beneficial interest. Note that
the accounting assumptions driving 1 and 2 above should be based on market realities, thus making the initial
and subsequent measurement methods consistent.

8. I account for all of my ABS investments in a “trading” account at fair value. Does 99-20 affect me?

Probably, although you don’t have to be concerned about an other-than-temporary impairment – the fair value
adjustment of trading assets embraces changes in value for any reason. Instead, the prospective interest
income guidance usually applies – assuming the ABS is within the scope of the issue.

9. In transition, how do I account for an existing ABS?

Regardless of a company’s year-end, ABS investors apply EITF 99-20 on the first day of the fiscal quarter
beginning after December 15, 2000. While earlier application is permitted, previously issued financial
statements are not restated.

The initial application of Issue 99-20 will require some investors to immediately record an other-than-
temporary impairment on January 1 (or sooner, if the consensus is applied earlier). The investor accounts for
the write down as a cumulative change in accounting principle – i.e. as a separate income statement line, net of
tax effects. 8 If the ABS is other-than-temporarily impaired under existing GAAP, the cumulative effect
adjustment excludes the existing impairment – that’s recorded in the quarter it occurs.

8
See APB Opinion 20. Pro forma disclosures are not required and the consensus deviates from APB 20’s requirement
that a change in accounting principal be applied during the first quarter of an entity’s fiscal year.

Attachment 1 Page 6
 Attachment 2
EITF 00-199
Tentative Consensus
Conditions Required for Equity (or Temporary Equity) Treatment

Required Condition (All Must Be Present) Explanation

1* The contract permits the company to settle in The ability to effect a registration statement is
either registered or unregistered shares (that outside of the company’s control. Thus, the contract
is, the ability to deliver registered shares is must permit delivery of unregistered shares.
outside the control of a company).
2* The company has sufficient authorized but The Task Force tentatively concluded that the need
unissued shares available to settle the to obtain shareholder approval of additional share
contract after considering all other authorizations is outside the control of the company.
commitments that may require the issuance
of stock during the period the derivative
could remain outstanding.
3* The contract contains an explicit limit on the The Task Force tentatively concluded that a
number of shares to be delivered in a share limitation is required to determine whether a
settlement. This limit must apply even if the company has sufficient authorized and unissued
contract terminates when the stock price shares to settle the contract.
reaches a stated price trigger.
4 There is no requirement in the contract to Collateral requirements are inconsistent with equity
post collateral at any point or for any reason. treatment.
5* There are no required cash payments to the Required cash payments are inconsistent with equity
counterparty if the shares initially delivered treatment.
are subsequently sold by the counterparty
and the sales proceeds are insufficient to
provide the counterparty with full return of
the amount due (that is, there is no cash
settled "top-off" or "make-whole" provision).
6 There are no provisions in the contract that Creditor rights are inconsistent with equity
indicate the counterparty has rights that rank treatment.
higher than those of a shareholder of the
stock underlying the contract.

* Physical settlement sometimes requires the Company to write a check (e.g. upon exercise of a put option it
wrote or upon settlement of a forward purchase of shares). If the contract permits physical settlement but
doesn’t provide for the possibility of net share settlement, it would classify the contract as temporary
equity. Thus, if these contracts require physical settlement (or give the Company the option of physical or
net cash settlement) the asterisked conditions do not apply.

The EITF explored a boatload of related issues at the July meeting. Contact Robert Canaan
(rcanaan@dttus.com) for a copy of the final minutes.

9
Determination of Whether Share Settlement is Within the Control of the Issuer for Purposes of Applying Issue No. 96-13,
“Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”