Financial Accounting Manual
- Revision Set 53
- Chapter 1. Balance Sheet
- Chapter 2. Collateral and Custodies
- Chapter 3. Property and Equipment
- Chapter 4. Central Bank Unique Accounting
- Chapter 5. Federal Reserve Notes
- Chapter 6. Reporting Requirements
- Chapter 8. Special Topics
Chapter 8: Special Topics
- 80.01 General
- 81.01 Allowance for Loan Losses
- 81.02 Recognizing an allowance for loan losses
- 81.03 Measuring loan losses
- 81.04 Recording loan losses and charge-offs
- 81.05 Interest income recognition
- 81.06 Valuation allowance adjustments
- 81.07 Program specific analysis
- 81.08 Unfunded commitments
- 81.09 Troubled Debt Restructuring
- 81.10 Disclosure
- 82.01 Consolidation
- 82.02 Evaluating consolidation based on variable interests
- 82.03 Reconsideration of the primary beneficiary
- 82.04 Accounting for the VIE
- 82.05 Disclosure
- 82.06 Table 1 Framework for considering the consolidation of special purpose entities
- 82.07 Table 2 Definition matrix of investment company FASB ASC Topic 946-10
- 83.01 Valuation of Non-SOMA Financial Assets and Liabilities
- 83.02 Evaluating assets and liabilities under relevant accounting standards
- 83.03 Fair value measurements
- 83.04 Securities impairments
- 84.01 Guarantees
- 84.02 Definition of guarantees
- 84.03 Exclusions from guarantees
- 84.04 Determining when to recognize a guarantee
- 84.05 Initial measurement of a guarantee
- 84.06 Subsequent measurement of a guarantee
- 84.07 Disclosure
This chapter addresses the accounting for financial assets and liabilities for which the accounting policies are not specified in other FAM chapters. These financial assets and liabilities are not part of the System Open Market Account (SOMA) and should be accounted for in accordance with GAAP. This chapter provides general accounting guidance for the unique aspects of these assets and liabilities. Reserve Banks should work with RBOPS Accounting Policy and Operations Section to determine the appropriate accounting treatment for the transactions described in this chapter and to obtain approval for the accounting analysis and related conclusions.
81.01 Allowance for Loan Losses
The Federal Reserve offers a number of lending facilities to help provide liquidity and funding to the financial markets. Under each facility, a Federal Reserve Bank (Bank) provided collateralized credit to eligible borrowers. These facilities include the following:
- Primary, secondary, and seasonal credit
- Term Auction Facility
- Primary Dealer Credit Facility and transitional credit extension
- AIG Credit Facility
- ABCP Money Market Liquidity Facility (AMLF)
- Term Asset-Backed Securities Loan Facility (TALF)
Loans extended by the Reserve Banks to consolidated limited liability companies (LLCs) are not considered in the following paragraphs because the loans are eliminated in consolidation. In addition, TALF loans and loans extended to consolidated LLCs that are recorded at fair value do not require an allowance for loan loss.
In accordance with FAM 1.06, Reserve Banks are required to accrue a loss on a loan when it is probable that the loan will be not be collected in full and when the amount of loss is reasonably estimable. The following paragraphs discuss key considerations for accounting for loan losses: (1) recognizing an allowance for loan losses, (2) measuring loan losses, (3) recording loan losses, (4) interest income recognition, and (5) disclosure.
81.02 Recognizing an allowance for loan losses
FASB ASC Topic 310-10; formerly SFAS No. 114 and FASB ASC Topic 450-20; formerly SFAS No. 5 address evaluating loan losses and impairments in loan portfolios. The Bank should recognize an allowance for loan loss when it is probable that the Bank will be unable to collect all amounts due, including both the contractual interest and principal payments under the loan agreement. Based on current information and events, if it is probable that a loan loss has been or will be incurred and the amount of the loss can be reasonably estimated, a loan loss should be recorded.
FASB ASC Topic 310-10; formerly SFAS No. 114 applies to all loans that are individually identified for evaluation, uncollateralized as well as collateralized. A loan is defined under FASB ASC Topic 310-10; formerly SFAS No. 114 as the contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor's balance sheet. FASB ASC Topic 310-10; formerly SFAS No. 114 provides guidance on evaluating loan losses for specific loans for which the risk characteristics are unique to an individual borrower. Consider the following triggering events:
- For a loan with an insignificant delay or shortfall in the amount of payments, it is not necessary to consider it impaired if the Bank expects to collect all amounts due, including interest accrued at the contractual interest rate, during the period the loan is outstanding.
- Indicators for assessing individual loans for impairments may typically include
- Loans experiencing severe delinquency, where the Bank does not believe the borrower can pay all amounts due.
- Strong indication of credit deterioration of the borrower such that default is probable.
- Deterioration of the fair value of the loan collateral and the inability of the borrower to provide additional collateral to make up for the shortfall.
The FASB ASC Topic 450-20; formerly SFAS No. 5 analysis is used for pools of homogeneous loans and applies to all loans, except for those that are recorded at fair value and those that are deemed impaired and individually assessed under FASB ASC Topic 310-10; formerly SFAS No. 114.1 FASB ASC Topic 450-20; formerly SFAS No. 5 provides guidance on evaluating loan losses for loans in homogenous portfolio segments with similar characteristics (i.e., pools of similar loans). This approach is typically quantitatively assessed based on historic net loss experience. Under FASB ASC Topic 310-10; formerly SFAS No. 114, the Bank should recognize an allowance when it is probable that not all principal and/or interest will be collected, and the amount of the loss can be reasonably estimated.
The term "probable" means an area within a range of the likelihood that a future event or events will occur confirming the loss. The range is from probable to remote, as follows:
- Probable. The future event or events are likely to occur.
- Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely.
- Remote. The chance of the future event or events occurring is slight.
- Whether the amount of loss can be reasonably estimated will normally depend on the experience of the enterprise, information about the ability of individual debtors to pay, and appraisal of the receivables in light of the current economic environment. In the case that the Bank has no experience of its own, reference to the experience of other entities with similar types of loans may be appropriate.
- An allowance for loan losses should be recognized only if it is probable that not all principal and/or interest will be collected. Some factors that should be considered when evaluating whether it is probable that not all principal and/or interest will be collected are discussed at paragraph 81.03.
If a loan has been individually evaluated for impairment in accordance with FASB ASC Topic 310-10; formerly SFAS No. 114, it generally would not also be subject to evaluation as part of a homogenous pool under FASB ASC Topic 450-20; formerly SFAS No. 5. If, however, the FASB ASC Topic 310-10; formerly SFAS No. 114 evaluation does not consider all of the risk characteristics that apply to a pool of loans in the aggregate (but not to individual loans), such as industry and concentration risk, it may be necessary to also include the loan in the FASB ASC Topic 450-20; formerly SFAS No. 5 evaluation.
The following diagram provides an illustrative decision tree for evaluating the need to record impairments or loan losses as of the evaluation date.
Application of Statements 5 and 114 to a Loan Portfolio
Application of FASB ASC Topic 450-20; formerly SFAS No. 5 and FASB ASC Topic 310-10; formerly SFAS No. 114 to a Loan Portfolio, Topic No. D-80.
81.03 Measuring loan losses
In this Section:
To determine whether it is probable that not all principal and/or interest will be collected and an allowance for loan losses should be recorded, the Bank should consider all relevant factors, including a) the occurrence of significant changes in the borrower's financial position that indicate that the borrower may not be able to repay the obligation, in whole or part, b) whether the proceeds from collateral will not be sufficient to pay the loan, c) historical experience with similar loans and d) whether the Banks have exhausted all commercially reasonable means of recovering the loan balance.
Measuring impairment for loans individually assessed under FASB ASC Topic 310-10; formerly SFAS No. 114
Based on the nature of the lending program, the Bank should select and apply consistently one of the three methods below. It is acceptable to select different measurement methods for different loan programs, based on the availability of information and other factors, including the Bank's reasonable expectations for the recovery of the investment in the loan. The measurement method for an individual impaired loan, however, should be applied consistently to that loan and a change in method should be justified by a change in circumstances.
- The present value of expected cash flows discounted at the loan's effective interest rate; or as a practical expedient
- The loan's observable market price; or
- The fair value of the collateral if the loan is nonrecourse.
1) Present value of expected cash flows method
Based on reasonable and supportable assumptions and projections, the Bank must exercise significant judgment to develop the best estimates of expected future cash flows. All available inputs, including estimated selling costs if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan, should be considered in developing the estimate of expected future cash flows. The weight given to the inputs should be commensurate with the extent to which the factors can be verified objectively. If the Bank estimates a range for either the amount or timing of possible cash flows, the likelihood of the possible outcomes shall be considered in determining the best estimate of expected future cash flows.
Other considerations may exist such as loan-specific credit protection in the form of a guarantee or credit insurance feature.3 In the case of a non-derivative credit enhancement that is separable from the loan such that its benefits do not follow with or are extinguished with the loan, any expected recoveries from credit enhancements cannot be used to offset the recorded amount of the allowance for loan loss for the impaired loan.
If the credit enhancement is attached to the loan, such that it always follows the loan upon its sale, the proceeds of such enhancements may be considered in the loss estimation.The Bank should consider potential recovery from third-party guarantors such as FDIC, other government agencies, or bond insurance. Additional recourse to consider is the ability to debit the borrower's account with the Federal Reserve. The Bank should consider all the cash flows associated with the loan and its specific credit protections when measuring the incurred loss in individually impaired loans and in determining the adequacy of the loss.
In addition, the basis for the cash flow estimates must be documented and subject to appropriate review procedures.
2) Market price method (as a practical expedient)
Because of the nature of the loans extended by the Reserve Banks, no market generally exists. The Bank can, however, measure impairment of a loan by reference to the market price of the loan, when a secondary market price exists for the loan. The Bank also needs to consider whether the methodology for determining the loan's observable market price complies with FASB ASC Topic 310-10; formerly SFAS No. 114. Issues to consider include (a) whether there is a market for the impaired loan and (b) whether the market price of the loan is observable.
3) Collateral value method (as a practical expedient)
The Bank can also measure the impairment of a loan by reference to the fair value of the collateral if the loan is nonrecourse, for example, if the repayment of the loan is expected to be provided solely by the underlying collateral.4 The estimated costs to sell, on a discounted basis, should be considered in the measure of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan. Selling costs should be adequately documented and supported.
The impairment of all loans on which default is probable is measured based on the fair value of the collateral, regardless of the measurement method that might have been used prior to default.
Measuring loan losses for a homogenous pool of loans under FASB ASC Topic 450-20; formerly SFAS No. 5.
For a large pool of small-balance loans and other loans not individually identified as impaired, a primary determination of the loss accrual under a lender's policy is often the historical loss experience ratio adjusted for current trends and conditions. The Bank can use available historical information to develop a range of expected losses.
Expected loss is the estimate of the current amount of loans for which it is probable that the Bank will be unable to collect given facts and circumstances as of the evaluation date. Based on historical experience, evaluate the degree of likelihood that the borrowers will not pay, the amount of funds lost when the borrowers default, and the total amount the Bank may lose, or the Banks' financial exposure to at the time of default. The calculation is based on a formula commonly used in practice to develop a FASB ASC Topic 450-20; formerly SFAS No. 5 allowance:
$Expected Loss = PD% * LGD% * $EAD5
FASB ASC Topic 310-10; formerly SFAS No. 114 quantitative measure
As a general practice, PD is based on the borrower's risk rating or credit rating and LGD/EAD is based on the underlying collateral and other recourse for each individual loan. The specific approach should be suitably developed for each program given the nature of underlying portfolio and data availability as discussed below.
The loans extended by the Banks under each facility are collateralized. They differ, however, in that some loans are with recourse while others are extended on a nonrecourse basis to the borrowers. As a result, the loss calculation for each differs. For example,
- For nonrecourse loans, this calculation should be based on the underlying collateral of the individual loan rather than the loan counterparty, because the pledged collateral is the only source of recovery in the event of the borrower's default on the loan.
- For recourse loans, this calculation should be based on the credit quality of the loan counterparty as well as the underlying collateral, because the Bank can recover by liquidating the underlying collateral as well as from the borrower itself.
For some loan programs, there may be insufficient historical loss experience to use to estimate the PD and LGD. Alternatives methods include
- Default and recovery rates based on historical studies of similar loans, as applicable;
- Default and recovery rates based on structured finance rating or corporate default study (e.g., S&P, Moody's)
The Bank should also consider factors that might cause the loss experience for the current loan portfolio to differ from historical experience or from a comparison to other default and recovery rates, such as current market conditions, credit concentration, extraordinary portfolio characteristics, and other environmental factors.
Subsequent to the initial measurement of an impairment, if there is a significant change in the amount or timing of the expected future cash flows of an impaired loan, the Bank should recalculate the impairment by applying the principles described above and adjust the valuation allowance.
If the Bank measures impairment based on the observable market price of an impaired loan or the fair value of the collateral of an impaired nonrecourse loan, it should adjust the valuation allowance if there is a significant change in either the market price or fair value. The net carrying amount of the loan should at no time exceed the recorded investment in the loan.
Periodic evaluations should be performed, but no less than quarterly. When performing the review, the Bank should evaluate whether the actual amount and timing of cash flows received from the borrower are consistent with the Bank's previous expectations. The review should take into account any information, events, or other developments as of the reporting date that may affect the Bank's previous estimate of impairment.
81.04 Recording loan losses and charge-offs
Recording the loan loss
If the estimated realizable amount of a pool of homogenous loans or a specific loan is less than the recorded investment in the loan(s), the Bank should recognize the loan loss by creating a valuation allowance with a corresponding charge to bad debt expense account or by adjusting an existing valuation allowance for the loans with a corresponding charge or credit to bad debt expense account. The valuation allowance should be recorded to FR 34 Account 145-360, Allowance for Loan Losses (credit); the expense provision should be recorded to Account 330-100, Profit and Loss, Net (debit).
The amount of the required valuation allowance is equal to the difference between the loan's impaired value (expected realizable value) and the recorded investment. The required charge or credit to bad debt expense is equal to the difference between the required valuation allowance and any existing valuation allowance related to that loan.
The recorded investment in the loan includes the outstanding loan balance (net of any charge-offs), accrued interest, deferred loan fees or costs, and unamortized premium or discount.
The net carrying amount of the loan is equal to the recorded investment in the loan less the valuation allowance, or the impaired value. When the Bank determines that a portion of the loan or the entire loan will be uncollectable, the recorded investment in the loan is written down by recording a charge-off against the loan and the valuation allowance. In no circumstances should the net carrying amount of the loan exceed the recorded investment in the loan.
The allowance for loan losses (on both individual loans evaluated under FASB ASC Topic 310-10; formerly SFAS No. 114 and homogeneous pool of loans evaluated under FASB ASC Topic 450-20; formerly SFAS No. 5) effectively adjusts the loan portfolio to its realizable value. Recoveries on previously charged-off amounts will reduce this allowance account.
When the loans become uncollectible, a charge-off will be recorded by reducing both loan balance (credit) and allowance for loan losses (debit). If the previously recorded valuation allowance is not sufficient to cover the charge-off, the difference should be recognized as an adjustment to the bad debt expense (debit) and allowance for loan losses (credit) in the current period.
81.05 Interest income recognition
In this Section:
Accrual of interest on impaired loans
When it is probable that the Bank will be unable to collect all or some of the amounts due, including both the contractual interest and principal payments under the loan agreement, the individual loan is considered to be impaired under FASB ASC Topic 310-10; formerly SFAS No. 114, and the accrual of interest income on that loan should be suspended.
The recognition of interest income based on the contractual terms of the loan agreement should be discontinued while the loan is considered impaired because any such interest will not be earned (i.e. the Bank does not expect to collect all of the interest and principal in accordance with the contractual terms of the loan agreement).
Subsequent payments on impaired loans
Two accounting practices exist for recording cash payments that are periodically received on the impaired loans: the cash basis method and the modified cost recovery method. The Banks should apply the modified cost recovery method to recover the investment in the loan prior to recognizing interest income, unless contract terms specify treatment. This method is more conservative because it defers income recognition until the principal is recovered.
Cash basis method
Under the cash basis method, payments of interest received are recorded as interest income provided the amount does not exceed that which would have been earned at the historical effective interest rate.
Modified cost recovery method
Under the modified cost recovery method, any interest or principal received is recorded as a direct reduction of the recorded investment in the loan. When the recorded investment has been fully collected, any additional amounts collected are recognized as interest income. This method may result in the recorded investment being less than the present value of the loan because the recorded investment excludes interest income and the present value includes interest.
81.06 Valuation allowance adjustments
At the end of the reporting period, changes in the loan's impaired basis due to the passage of time (changes in discounted present value) are reflected in the income statement using either the interest method or the bad debt expense method. Because it is more consistent to apply across the spectrum of programs offered by Reserve Banks, the Banks should apply the bad debt expense method.
The change in the present value of a loan should be assessed to identify the changes because of the passage of time and the changes that are because of the amount or timing of expected future cash flows. The increase in present value attributable to the passage of time can be reported as interest income accrued on the net carrying amount of the loan. The change in present value, if any, attributable to changes in the amount or timing of expected future cash flows can be reported as bad debt expense or as a reduction in the amount of bad debt expense that otherwise would be reported.
Bad-debt expense method
The entire change in present value can be reported as bad debt expense or as a reduction in the amount of bad debt expense that otherwise would be reported.
81.07 Program specific analysis
In this Section:
Loans should be evaluated quarterly, in accordance with the process described below. Each Reserve Bank should establish appropriate oversight of the review process, including review by the Chief Financial Officer and other Reserve Bank senior management, as appropriate. The process is comprised of four steps:
- Identification of the loans that are to be evaluated for collectability based on FASB ASC Topic 450-20; formerly SFAS No. 5 or FASB ASC Topic 310-10; formerly SFAS No. 114.
- Determination of the collectability of the loans identified for evaluation.
- Determination of a loss allowance for loans for which the Bank concluded that a loss is probable.
- On a quarterly basis, the Bank should submit its evaluation of loan loss, and relevant supporting documentation to RBOPS Accounting Policy and Operations Section on the 15th of the month following quarter-end, or the next business day if the 15th is a weekend or holiday. The analysis should be prepared in a format acceptable to the RBOPS Accounting Policy and Operations Section.
Based on a Reserve Bank's daily monitoring, if a loan is deemed to be impaired, the RBOPS Accounting Policy and Operations Section should be notified immediately.
Primary, Secondary, and Seasonal Credit; Term Auction Facility Lending; and Emergency Credit
The Federal Reserve Banks' lending serves as a backup source of liquidity for depository institutions. At times when the normal functioning of financial markets is disrupted, Federal Reserve Banks lending can become a principal channel for supplying liquidity to depository institutions and other entities.
Regulation A, Extensions of Credit by Federal Reserve Banks, governs borrowing by depository institutions and provides terms and conditions for several lending programs, detailed below. The terms under which a depository institution may obtain advances from, incur obligations to, or pledge collateral to a Federal Reserve Bank in borrowing are set forth in Operating Circular No. 10, which is issued by each Reserve Bank. Regulation A governs primary, secondary, seasonal, term auction, and emergency credit.
- Primary credit is only available to generally sound depository institutions, usually on a very short-term basis, typically overnight.8 On March 17, 2008, the primary credit program was temporarily changed to allow primary credit loans for terms of up to 90 days. Primary credit is generally priced at a rate above the FOMC's target for the federal funds rate.
- Secondary credit is available to depository institutions that are not in generally sound condition and are therefore not eligible for primary credit.9 It is extended at the discretion of the Reserve Bank and on a very short-term basis, typically overnight, at a rate that is generally above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. The secondary credit program is stringently administered in that Reserve Banks normally require potential borrowers to describe alternative funding sources, funding needs, and repayment plans in detail, prior to making a secondary credit loan.
- Seasonal credit is designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits.10 Seasonal credit is usually made available to depository institutions in generally sound condition that can demonstrate a clear pattern of recurring intra-yearly swings in funding needs. Eligible institutions are usually located in agricultural or tourist areas. The interest rate applied to seasonal credit is a floating rate based on market rates.
- Term Auction Facility credit is a temporary program introduced in 2007 that is available to generally sound depository institutions that are expected to remain in that condition during the term of the advance. Term auction facility credit extensions are made pursuant to an auction conducted subject to such factors as the participants, size and duration of the facility, minimum bid amount, maximum bid amount, term of advance, minimum bid rate, use of proceeds, and schedule of auction dates, as the Board may establish from time to time in connection with the term auction facility.
- Emergency credit is only available in unusual and exigent circumstances to individuals, partnerships, and corporations, and requires authorization by the Board of Governors under section 13(3) of the Federal Reserve Act. Extensions of emergency credit may be made under the terms of Operating Circular No. 10 or other agreements. In certain circumstances, emergency credit may be offered through specifically defined targeted programs that are administered by a designated Reserve Bank.
Federal Reserve Banks extend credit on a secured basis. Satisfactory collateral generally includes United States government and federal-agency securities, foreign debt, municipal and corporate debt, commercial paper and bank-issued assets, and commercial and consumer obligations, including real estate related loans. Collateral must be of acceptable credit quality to the Reserve Bank and performing under its terms and conditions. In accordance with Operating Circular No. 10, the borrower assigns to the lending Reserve Bank a continuing security interest in and lien on the collateral as collateral security for the timely and complete payment and performance when due. Reserve Banks take additional steps to perfect their security interest under the provisions set forth in the Uniform Commercial Code.
Assets accepted as collateral are assigned a lending value (market or face value reduced by a margin) deemed appropriate by the Reserve Bank.11 The financial condition of an institution and the impairment of any collateral are considered when assigning value. The lending Reserve Bank may request the borrower to replace any item of collateral or pledge additional collateral at any time.
Operating Circular No. 10 specifies that, in the event of a default, the Bank may pursue remedies including debiting (or causing to be debited if the borrower is acting through a correspondent) the borrower's account.
Loans are accounted for on the books of the Reserve Bank with which the borrower has the agreement to borrow.
(1) Identify loans that are to be evaluated for collectibility
Factors to consider in determining whether the loans can be individually analyzed for collectability are discussed below:
- Primary, term auction facility (TAF), and seasonal credit:
- While generally overnight, the term for primary credit loans may be up to 90 days; TAF loans are up to 84 days; under the seasonal credit program, loans can be extended for up to 9 months during a calendar year;
- These loans are made to depository institutions deemed to be in generally sound financial condition; and
- The loans require similar types of collateralization and are recourse loans as specified in Operating Circular 10.
- Secondary and emergency credit:
- The nature and terms of these loans are not homogenous.
- For both the secondary and emergency loan programs, the financial institutions involved are in some degree of financial distress.
Assessment: Although some loans may warrant individual assessments under FASB ASC Topic 310-10; formerly SFAS No. 114, these loans are generally homogenous in nature and should be evaluated in aggregate in accordance with FASB ASC Topic 450-20; formerly SFAS No. 5.
Assessment: These loans are not homogenous in nature and should be evaluated individually in accordance with FASB ASC Topic 310-10; formerly SFAS No. 114.
(2) Evaluate loans for collectibility
For the programs deemed to be homogenous, perform a FASB ASC Topic 450-20; formerly SFAS No. 5 evaluation based on terms of the loans, historical loss experience, and loss mitigation procedures that are followed by the Reserve Banks. The Banks should consider the history of the primary and seasonal loan programs, and whether there has ever been a loss. Additionally, consider the condition monitoring that the Bank performs, information obtained from banking supervisors, the subject institution, the market, and public sources.
The Bank's loans should be considered impaired, when, based on current information and events, it is probable that the Bank will be unable to collect all or some of the amounts due according to the contractual terms of the loan. Per FASB ASC Topic 310-10; formerly SFAS No. 114, this process requires considerable management judgment. The analysis should include the following elements:
- Review the information concerning the viability of the borrower as an on-going concern through Reserve Bank condition monitoring, including information obtained from banking supervisors, the subject institution, the market, and public sources.
- Review the capitalization of the institution. Section 142 of FDICIA states that even adequately collateralized loans made to critically undercapitalized depository institutions pose a risk of loss to the Federal Reserve.
- Review the history to determine if the loan has been renewed on a roll-over basis. Evaluate whether the successive loans represent a greater probability of a loss. Consider the length of time outstanding, if amounts borrowed increased, etc.
- Review the institution's Federal Reserve account balance to determine whether the balance is sufficient to repay the loan. Per Operating Circular No. 10, the Reserve Bank may debit the borrower's account for the advance repayment amount and all other obligations when due. The Reserve Bank cannot, however, require specific balances to be held. A sufficient account balance may make it less than probable that a loss would be incurred.
Emergency credit offered through specifically defined targeted programs that are administered by a designated Reserve Bank likely will have a unique profile. Accordingly, specific evaluation and valuation criteria, while consistent with the methodology described herein, should be developed for each program. Certain programs, such as the AMLF and PDCF, are discussed separately below.
(3) Determine loss allowance
The Reserve Bank should evaluate the fair value of the collateral to determine if a loss allowance for the identified loan is appropriate.
- If the fair value of the collateral is greater than the recorded investment in the loan, there is no loss allowance to be recorded.
- If the fair value of the collateral is lower than the recorded investment in the loan, determine whether the loan is impaired under FASB ASC Topic 310-10; formerly SFAS No. 114.
- If applicable to the specific loan, review any coverage provided by the indemnity agreement between the FDIC or National Credit Union Administration and the Reserve Bank. A loan covered by the indemnity agreement has less probability that a loss will be incurred because the agreement allows the Federal Reserve to recover the amount lent up to the fair value of the collateral.
ABCP Money Market Liquidity Facility Program (AMLF)
The AMLF was announced on September 19, 2008, to help money market mutual funds meet demand for redemption and restore liquidity to the ABCP market. This program allows eligible borrowers (depository institutions and bank holding companies) to borrow funds from the Reserve Bank to fund the purchase of eligible ABCP from a registered investment company that qualifies as a money market mutual fund (MMMF). Eligible ABCP collateralizes the loan and must be rated no lower than A1, P1, or F1 by at least two major rating agencies. ABCP is purchased by the borrower from the MMMF at amortized cost. The terms for AMLF loans are up to 120 days for banks and 270 days for nonbank borrowers. The loans require collateralization and are nonrecourse to the borrower.
(1) Identify loans that are to be evaluated for collectability
AMLF loans are extended to eligible depository institutions and bank holding companies, and are backed by collateral consisting of highly-rated asset-backed commercial paper. The loss analysis should be performed using FASB ASC Topic 310-10; formerly SFAS No. 114 based on triggering events, such as change in collateral rating or value, delay in payments or insufficient payment streams, or adverse public information regarding the entity.
(2) Evaluate loans for collectability
Once it is probable that the Bank will be unable to collect all amounts due under the contractual terms of the loan agreement, the loan is impaired. Because AMLF loans are nonrecourse to the borrower, the evaluation should be based collectability of the underlying collateral. When the ABCP is in default, it is probable that the future contractual cash flow (including both the contractual interest payments and the contractual principal payments of the loan) is impaired. Thus, the Bank should evaluate these loans for collectability based on its collateral monitoring.
(3) Determine loss allowance
If triggering events were identified, and particular loans were segregated for analysis under FASB ASC Topic 310-10; formerly SFAS No. 114, use the fair value of underlying collateral will be used to measure impairment.
- If the fair value of the collateral is lower than the recorded investment in the loan, then the loan is impaired and a FASB ASC Topic 310-10; formerly SFAS No. 114 allowance should be recorded.
- If the fair value of the collateral is greater than the recorded investment in value of the loan, then no allowance is needed.
Primary Dealer Credit Facility (PDCF) and transitional credit extension12
Primary dealers may obtain secured overnight financing under the PDCF, in the form of repurchase transactions, with all collateral eligible for pledge in tri-party funding arrangements through the major clearing banks. Secured financing made under the PDCF are made with recourse to the primary dealer.
(1) Identify loans that are to be evaluated for collectability
The PDCF and transition credit extension loans are made to primary dealers deemed to be in generally sound financial condition. Because there will typically be a relatively small number of loans extended at any one time and the loans are generally for large amounts, it may be more practical to evaluate these loans on an individual basis rather than as a pool of loans. The recorded investment in each loan should be compared to the fair value of pledged collateral to determine if an impairment is indicated.
(2) Evaluate loans for collectability
Given that PDCF loans are fully collateralized and with recourse to the borrower, the evaluation should be based on the underlying collateral as well as the credit quality of the primary dealers. It is possible that the future contractual cash flow (including both the contractual interest payments and the contractual principal payments of the loan) would not be impaired even when the underlying collateral is non-performing.
(3) Determine loss allowance
The fair value of underlying collateral should be used to measure FASB ASC Topic 310-10; formerly SFAS No. 114 impairment.
- If the fair value of the collateral is lower than the recorded investment in the loan, then assess the credit quality of the borrower to determine whether a FASB ASC Topic 310-10; formerly SFAS No. 114 reserve is needed.
- If the fair value of the collateral is greater than the value of the loan, then no reserve is needed.
81.08 Unfunded commitments
Identify unfunded commitments that are to be evaluated for likelihood of occurrence
For secured lending facilities, the Bank specifies the maximum amount of funding it will provide. The remaining amounts available to borrow under each facility are the "unfunded commitments." Unfunded commitments, such as loan commitments or financial guarantees, represent off-balance sheet credit exposures and should be evaluated for impairment. See paragraph 84.01 Accounting for Guarantees for additional discussion. Impairments that are probable and reasonably estimable should be recorded in the financial statements, while impairments that are not reasonably estimable should be disclosed in the accompanying notes to the financial statements.
81.09 Troubled Debt Restructuring
Modification of the terms of a loan may qualify as a troubled debt restructuring if the Bank, for economic or legal reasons related to the debtor's financial difficulties, grants a concession that it would not otherwise have considered. The following types of loan modifications may trigger an evaluation to determine if the restructuring qualifies as a troubled debt restructuring:
- Reduction of the stated interest rate
- Extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risks
- Reduction of the principal amount of the debt
- Reduction of the accrued interest.
If any of the above criteria are met, the amount of the impairment loss is measured as the excess of the current recorded investment in the loan over the present value of modified cash flows discounted at the loan's original contractual effective interest rate. The impairment loss should be recorded to the allowance for loan restructuring account and to provision for loan loss. The loan should be periodically evaluated and, if necessary, adjustments should be recorded to the allowance for loan restructuring and provision for loan loss.
If the Bank expects that, after restructuring the loan, it will be able collect all amounts in accordance with the revised terms of the loan agreement, it should continue to record interest income. If, however, the Bank does not expect to collect all amounts in accordance with the revised terms of the loan agreement, it should discontinue recording interest income and follow the procedures described in paragraph 81.05.
Disclosure under FASB ASC Topic 450-20; formerly SFAS No. 5
The Bank shall disclose, either in the body of the financial statements or in the accompanying notes, the following information about allowances under FASB ASC Topic 450-20; formerly SFAS No. 5:
- The nature of an accrual made pursuant to FASB ASC Topic 450-20; formerly SFAS No. 5, the methodology used to develop the accrual, and the amount accrued.
- If no accrual is made, but there is at least a reasonable possibility that a loss or an additional loss may have been incurred, disclose
- The nature of the contingency;13
- The estimate of the possible loss or range of loss or state that such an estimate cannot be made.
- After the date of the Bank's financial statements but before those financial statements are available for issuance, if information becomes available indicating that a loan was impaired or that there is at least a reasonable possibility that a loan was impaired, disclose
- The nature of the loss or loss contingency;
- The estimate of the amount or range of loss or possible loss or state that such an estimate cannot be made;
- In the case of a loss arising after the date of the financial statements where the amount of loan impairment can be reasonably estimated, disclose pro forma financial data on the loss as if it had occurred at the date of the financial statements.
- Certain loss contingencies are disclosed even though the possibility of loss may be remote. The common characteristic of those contingencies is a guarantee, usually with a right to proceed against an outside party in the event that the guarantor is called upon to satisfy the guarantee.14 Examples include
- Guarantees of indebtedness of others,
- Obligations of commercial banks under "standby letters of credit," and
- Guarantees to repurchase receivables that have been sold or otherwise assigned.
- The nature and amount of the guarantee;
- If estimable, the value of any recovery that could be expected to result, such as from the guarantor's right to proceed against an outside party.
The disclosure shall include
Disclosure under FASB ASC Topic 310-10; formerly SFAS No. 114
The Bank shall disclose, either in the body of the financial statements or in the accompanying notes, the following information about loans that meet the definition of an impaired loan under FASB ASC Topic 310-10; formerly SFAS No. 114:
The total recorded investment in the impaired loans at the end of each period, and
(1) The amount of that recorded investment for which there is a related allowance for credit losses and the amount of that allowance, and
(2) The amount of that recorded investment for which there is no related allowance for credit losses determined in accordance with this FASB ASC Topic 450-20; formerly SFAS No. 5;
- The Bank's policy for recognizing interest income on impaired loans, including how cash receipts are recorded.
- The average recorded investment in the impaired loans during each period, the related amount of interest income recognized during the time within that period that the loans were impaired, and, if practicable, the amount of interest income recognized using a cash-basis method of accounting during the time within that period that the loans were impaired
- The activity in the total allowance for credit losses related to loans, including
- The balance in the allowance at the beginning and end of each period,
- Additions charged to operations,
- Direct write-downs charged against the allowance, and
- Recoveries of amounts previously charged off.
Additional disclosure under FASB ASC Topic 310-10; formerly SFAS No. 118
Additional disclosures about impaired loans are required under FASB ASC Topic 310-10; formerly SFAS No. 118, including
- The total recorded investment in impaired loans;
- The policy for interest income recognition on impaired loans including how cash receipts are recorded;
- The average recorded investment in the impaired loans during the period; and
- The details of the activity in the allowance for credit losses.
The Federal Reserve offered funding markets access to liquidity by introducing a number of liquidity facilities that were authorized by the Board under Section 13(3) of the Federal Reserve Act. The facilities were structured such that a specific Federal Reserve Bank (Bank) provided funding to a special purpose vehicle/entity (SPV or SPE), which in turn acquired certain targeted assets from third party entities.15
- FASB ASC Topic 810-10; formerly FIN No. 46R, amended by SFAS 167, requires consolidation of SPVs and SPEs that are within the scope of the standard, meet the definition of a variable interest entity (VIE), and meet the other criteria specified in FASB ASC Topic 810-10; formerly FIN No. 46(R). A VIE is an entity for which the value of the beneficiaries' financial interests in the entity change with changes in the fair value of its net assets. A VIE is consolidated by the financial interest holder that is determined to be the primary beneficiary of the VIE.16 The primary beneficiary of an SPE is the financial interest holder that has a controlling financial interest, as defined in paragraph 82.02 .
The standard is based on the principle that if a business enterprise has a controlling financial interest in a VIE, the assets, liabilities, and results of the VIE operations must be included in the consolidated financial statements of the business enterprise.17 Although voting interests can create a controlling financial interest, it is important to understand that a controlling financial interest may exist through arrangements such as debt instruments and guarantees that do not involve voting interests.
82.02 Evaluating consolidation based on variable interests
In this Section:
To determine if a Bank must consolidate a SPE's assets, liabilities, and results of operations, it must first determine if the SPE is a business within the scope of FASB ASC Topic 810-10; formerly FIN No. 46(R).18 If the SPE in which the Bank has a financial interest is deemed to be a business, it is not subject to consolidation.Table 1 in paragraph 82.06 contains a framework that can be used in evaluating whether a VIE financial results must be consolidated in the financial statements of the Bank.
Next, the Bank should determine if the SPE is within the scope of FASB ASC Topic 810-10; formerly FIN No. 46(R). The SPE is within the scope of FASB ASC Topic 810-10; formerly FIN No. 46(R) if one or more of the following conditions exist:
- The Bank, or its related parties, participated significantly in the design of the entity;
- The entity is designed so that all of its activities either involve or are conducted on behalf of the Bank and its related parties;
- The Bank and its related parties provide more than half of the total of the equity, subordinated debt, and other forms of subordinated financial support to the entity, based on the fair values of the interests in the entity; or
- The activities of the entity are primarily related to securitizations or other forms of asset-backed financings.
If, based on the criteria in the paragraph above, the entity in which the Bank has a financial interest is determined to be within the scope of FASB ASC Topic 810-10; formerly FIN No. 46(R), the Bank must then determine if the entity is a VIE. The entity will meet the definition of a VIE if one or more of the following conditions are met:
- The total equity investment at risk is not sufficient to finance its activities without additional subordinated financial support. Generally, an equity investment at risk of less than 10% of the entity's total assets shall not be considered to be sufficient to finance its activities;
- As a group, the holders of the equity investment at risk lack any one of the characteristics of a controlling financial interest, which are 1) the ability, through voting rights, to make decisions about the entity's activities that have a significant effect on the success of the entity; 2) the obligation to absorb the expected losses of the entity; or 3) the right to receive the expected residual returns of the entity; or
- Where the relative voting rights of equity investors are different than their agreed upon obligation to absorb losses or right to receive expected residual returns, consideration should be given to each equity investor's obligations and rights, and not just only to its equity investment at risk.
If the entity meets the definition of a VIE outlined above, then the Bank's financial interest represents a variable interest and the Bank must consider whether it has a controlling financial interest in the VIE and, therefore, should include the assets, liabilities, and results of operations of the VIE in its consolidated financial statements. The Bank has a controlling financial interest and should consolidate the variable interest entity if it meets both of the following conditions:
- The power to direct the activities of a variable interest entity that most significantly affect the entity's economic performance.
- The obligation to absorb losses or right to receive benefits of the entity that could potentially be significant to the variable interest entity.
Only one enterprise, if any, is expected to be identified as the primary beneficiary of a variable interest entity. Although more than one entity could have either of the characteristics described above, only one entity, if any, will have the power to direct the activities of a variable interest entity that most significantly affect the entity's economic performance.
In certain circumstances, the Bank may determine that there is no primary beneficiary associated with a VIE. In these, circumstances, while variable interests exist, because there is no primary beneficiary no reporting entity consolidates the VIE.
Senior beneficial interests and senior debt instruments with fixed interest rates or other fixed returns normally would absorb little of the entity's expected variability and, therefore, a holder of the most senior interests of a VIE likely would not be the primary beneficiary of that entity unless the VIE's subordinated interests are not large enough to absorb the VIE's expected losses. Further, senior interests normally are not entitled to any of the expected residual returns. A Bank that holds a senior financial interest in a VIE, however, should perform an evaluation to determine if it is the primary beneficiary.
To determine if it is the primary beneficiary, the Bank must treat the financial interests (i.e., variable interests) held by its related parties as its own interests. For purposes of FASB ASC Topic 810-10; formerly FIN No. 46(R), related parties include those parties identified in FASB ASC Topic 850-10; formerly SFAS No. 57, as well other parties that are acting as de facto agents. The following are considered to be de facto agents of the Bank:
- A party with a financial interest in the VIE that cannot finance its own operations without subordinated financial support from the Bank, such as another VIE in which the Bank is the primary beneficiary;
- A party with a financial interest in the VIE that received its interests as a contribution or a loan from the Bank;
- An officer, employee, or member of the governing board of the Bank;
- A party that has a financial interest in the VIE and has an agreement that it cannot sell, transfer, or encumber its interests in the VIE without the prior approval of the Bank;
- A party that has a financial interest in the VIE and has a close business relationship with the VIE or other benficiaries of the VIE, like the relationship between a professional service provider and one of its significant clients.
If the Bank and another interest holder are considered to be related parties, and the combination of their interest would lead to a conclusion that the related party group is the primary beneficiary, then the party within the related group that is most closely associated with the VIE is the primary beneficiary for purposes of consolidation. Determining the primary beneficiary from among a related group requires judgment and consideration of qualitative factors, such as the following (no single factor is necessarily determinative):
- Existence of a principal-agency relationship between the parties (in this case the principal is the primary beneficiary);
- The relationship and significance of the activities of the VIE to the parties in the related group;
- The parties' exposure to the variability associated with the anticipated economic performance of the VIE;
- The design of the VIE, such as the capital structure and the intentions of the parties that created the entity.
Other considerations in evaluating consolidation of VIEs
A VIE (VIE 1) itself can hold variable interest in another VIE (VIE 2). If, in evaluating the above criteria, the Bank determines that VIE 1 is the primary beneficiary of VIE 2, then VIE 1 must consolidate VIE 2 in its separate financial statements. The effect of this multi-level consolidation is that VIE 1 will report the assets and liabilities of VIE 2, rather than simply the net investment in that entity. If the Bank is the primary beneficiary of VIE 1, it will, in effect, consolidate both VIE 1 and VIE 2.
If the Bank is the primary beneficiary of a VIE that qualifies as an investment company, the multi-level consolidation described in the preceding paragraph would not be required. FASB ASC Topic 810-10; formerly FIN No. 46(R) specifies that investments accounted for at fair value are not subject to consolidation according to the requirements of FASB ASC Topic 810-10; formerly FIN No. 46(R) in accordance with the specialized accounting guidance in the FASB ASC Topic 946; formerly Financial Services - Investment Companies. The following attributes of an investment company are specified in FASB ASC Topic 946; formerly Financial Services - Investment Companies:
- Investment activity. The investment company's primary business activity involves investing its assets, usually in the securities of other entities not under common management, for current income, appreciation, or both.
- Unit ownership. Ownership in the investment company is represented by units of investment, such as shares of stock or partnership interests, to which proportionate shares of net assets can be attributed.
- Pooling of funds. The funds of the investment company's owners are pooled to provide owners access to professional investment management.
- Reporting entity. The investment company is the primary reporting entity.
82.03 Reconsideration of the primary beneficiary
A Bank with an interest in a VIE shall reconsider whether it is the primary beneficiary throughout the reporting period or if one of the following events occurs:
- The VIE's governing documents or contractual arrangements are changed in a manner that reallocates between the existing primary beneficiary and other unrelated parties 1) the obligation to absorb the expected losses of the VIE or 2) the right to receive the expected residual returns of the VIE;
- The primary beneficiary sells or otherwise disposes of all or part of its variable interests to unrelated parties;
- The VIE undertakes additional activities, or acquires additional assets beyond those that were anticipated at the inception of the VIE formation, that increase the VIE's expected losses.
- The VIE issues new variable interests to parties other than the primary beneficiary or its related parties.
- The VIE becomes subject to consolidation by financial interest holders because the equity investors, as a group, lose the power (typically represented by voting rights or similar rights) to direct the activities of the entity in a manner that most significantly impact the entity's economic performance.
A variable interest holder does not subsequently become the primary beneficiary simply because the actual losses of the VIE exceed the expected losses.
82.04 Accounting for the VIE
The assets, liabilities, and noncontrolling interests shall be accounted for in consolidated financial statements as if the VIE were consolidated based on voting interests. Any specialized accounting requirements applicable to the VIE's business, assets, and liabilities shall be applied. Intercompany balances and transactions should be eliminated.
The primary beneficiary of a VIE shall disclose the following:
- The carrying amounts and classification of the variable interest entity's assets and liabilities in the statement of financial position that are consolidated in accordance with FASB ASC Topic 810-10; formerly FIN No. 46(R), including qualitative information about the relationship(s) between those assets and liabilities.
- Lack of recourse if creditors (or beneficial interest holders) of a consolidated variable interest entity have no recourse to the general credit of the primary beneficiary.
- Terms of arrangements, giving consideration to both explicit arrangements and implicit variable interests that could require the Bank to provide financial support to the variable interest entity, including events or circumstances that could expose the Bank to a loss.
If the Bank holds a significant variable interest, but is not the primary beneficiary, it should disclose the following:
- The carrying amounts and classification of the assets and liabilities in the Bank's statement of financial position that relate to the Bank's variable interest in the entity.
- The Bank's maximum exposure to loss as a result of its involvement with the variable interest entity, including how the maximum exposure is determined and the significant sources of the Bank's exposure to the variable interest entity. If the Bank's maximum exposure to loss as a result of its involvement with the variable interest entity cannot be quantified, that fact shall be disclosed.
- A tabular comparison of the carrying amounts of the assets and liabilities, as required by (a) above, and the Bank's maximum exposure to loss, as required by (b) above. A Bank shall provide qualitative and quantitative information to allow financial statement users to understand the differences between the two amounts. That discussion shall include, but is not limited to, the terms of arrangements, giving consideration to both explicit arrangements and implicit variable interests, that could require the Bank to provide financial support (for example, liquidity arrangements and obligations to purchase assets) to the variable interest entity, including events or circumstances that could expose the Bank to a loss.
- Information about any liquidity arrangements, guarantees, and/or other commitments by third parties that may affect the fair value or risk of the Bank's variable interest in the variable interest entity.
- If applicable, significant factors considered and judgments made in determining that the power to direct the activities of the variable interest entity that most significantly impact the entity's economic performance is shared.
Information about VIEs may be reported in the aggregate for similar VIEs if separate reporting would not add additional information. Any specialized disclosure requirements applicable to the VIE's business, assets, and liabilities shall be applied.
82.06 Table 1 Framework for considering the consolidation of special purpose entities
82.07 Table 2 Definition matrix of investment company FASB ASC Topic 946-10
|Guidance--definition matrix of investment company--FASB ASC Topic 946-10; formerly SOP 07-1|
1. Legal entity
The entity should be organized as a separate legal entity
2. Business purpose
For current income, capital appreciation, or both.
|3. Entity's activities limited to investment activities
|4. Multiple substantive investments
|5. Exit strategies
Identify exit strategies for its investments and the timing (or a range) of when it expects to exit the investments.
|6. Not for strategic operating purposes
Not to obtain benefits as a result of the investments or through relationships with the investee or its affiliates that are unavailable to non-investor entities.
FOLLOWING ARE OTHER FACTORS TO BE CONSIDERED WHEN ASSESSING WHETHER AN ENTITY IS INVESTING FOR STRATEGIC OPERATING PURPOSES
7. Number of substantive investors in the entity (pooling of funds)
|8. Level of ownership interests in investees
9. Substantial ownership by passive investors
|10. Substantial ownership by employee benefit plans
Substantial ownership by employee benefit plans provides evidence that the entity is investing for current income, capital appreciation, or both.
|11. Involvement in the day-to-day management of investees, their affiliates, or other investment assets
The more extensive the involvement in the day-to-day management of investees, their affiliates, or other investment assets, the greater the evidence that the entity is investing for strategic operating purposes.
12. Significant administrative or support services provided to investees or their affiliates
|13. Financing guarantees or assets to serve as collateral provided by investees for borrowing arrangements of the entity or its affiliates
|14. Provision of loans by noninvestment company affiliates of the entity to investees or their affiliates
|15. Compensation of management or employees of investees or their affiliates is dependent on the financial results of the entity or the entity's affiliates
The more extensive such compensation arrangements, the greater the evidence that the entity is investing for strategic operating purposes.
|16. Directing the integration of operations of investees or their affiliates or the establishment of business relationships between investees or their affiliates
In considering the above criteria and their effect on the conclusion about whether an entity is an investment company, some factors may be more or less significant than others, depending on the facts and circumstances, and therefore, more or less heavily weighted in determining whether an entity is an investment company. Criteria 1 through 6 may individually prevent an entity from being classified as an investment company, Criteria 7 through 16 (other factors) are to be evaluated both individually and on a combined basis. Any single criterion of 7 through 16 is not necessarily determinative of whether the entity is an investment company. All of the criteria, however, must be assessed qualitatively, and professional judgment will need to be exercised.
83.01 Valuation of Non--SOMA Financial Assets and Liabilities
This paragraph provides guidance on the valuation of financial assets and liabilities that are not held in the System Open Market Account (SOMA). The Reserve Banks, largely as a result of liquidity initiatives, have acquired financial assets and liabilities that are not part of SOMA. These financial assets and liabilities should be accounted for in accordance with GAAP applicable to commercial entities. In some cases, the assets are reported by a Reserve Bank through the consolidation of a variable interest entity (VIE), and the VIE, under the terms of its organization typically applies GAAP to these assets and liabilities. If appropriate, the Reserve Bank may accept the accounting applied by the VIE, but should review the accounting treatment in consultation with RBOPS Financial Reporting and Control Section to ensure consistent accounting for similar Bank assets.
83.02 Evaluating assets and liabilities under relevant accounting standards
Financial assets may include commercial paper, mortgage-backed securities, collateralized debt obligations, commercial and residential mortgages, derivative financial instruments, other asset-backed securities, preferred securities, and similar securities. Financial liabilities may include obligations arising under derivative financial instruments and obligations due third-party SPE financial interest holders.20 The Bank must carefully consider the nature of the financial instrument and the intent of the Bank in holding the instrument to determine the appropriate valuation approach. There are three primary GAAP requirements under which these assets and liabilities should be valued:
1) FASB ASC Topic 320-10; formerly SFAS No. 115, provides general guidance on the valuation of all debt securities and equity securities that have readily determinable fair values. Under FASB ASC Topic 320-10; formerly SFAS No. 115, the debt and equity securities are classified into three categories:
- Held-to-maturity securities are reported at amortized cost.
- Trading securities are reported at fair value, with unrealized gains and losses included in earnings.
- Available-for-sale securities are reported at fair value, with unrealized gains and losses reported in other comprehensive income (OCI) as a separate component of shareholders' equity.
In most cases, the non-SOMA financial assets of Reserve Banks will be regarded as either held-to-maturity or trading securities. Available-for-sale securities are usually those that are held for investment purposes, which is not a typical strategy for Bank holdings of such assets. Held-to-maturity classification is appropriate in those cases in which the Bank has both the intent and likelihood to hold the securities to maturity. For example, in the case of commercial paper which typically has a relatively short maturity, it may be most appropriate to account for the asset as held-to-maturity.. The trading-securities classification is appropriate in cases in which the stated intent with respect to the asset portfolio is an orderly liquidation of assets, since there is no intent to hold the assets to maturity.
Other real estate assets may be acquired as a result of defaults on the related collateralized asset. Such assets should be recorded at fair value at the date possession is taken of the asset and subsequently should be measured in accordance with paragraph 30.95. The facts and circumstances of each case may need to be evaluated in order to determine when possession occurs.
2) FASB ASC Topic 825-10; formerly SFAS No. 159, allows entities to voluntarily and irrevocably choose, at specified election dates, to measure many financial assets and financial liabilities at fair value. The election is made on an instrument-by-instrument basis. If the fair value option is elected for an instrument, all subsequent changes in fair value for that instrument must be reported in earnings.
Under FASB ASC Topic 825-10; formerly SFAS No. 159, measuring financial assets and liabilities at fair value is permissible for those assets and liabilities that would otherwise be classified as available-for-sale or held-to-maturity. Electing the fair value option might be appropriate to prevent valuing related assets and liabilities differently. For example, a financial asset and its related derivative, such as a hedging transaction, might be valued differently under FASB ASC Topic 320-10; formerly SFAS No. 115 whereas FASB ASC Topic 825-10; formerly SFAS No. 159 would permit valuing both using fair value. This might reduce volatility in reporting earnings and better reflect the overall economics of the transactions. Another example might be one in which a specific financial liability will be settled from the proceeds of a portfolio of assets; in this case it would be desirable to measure the related assets and liabilities on a similar basis.
The fair value option can be elected for the following items:
- Loan and mortgage receivables
- Debt and equity investments (available-for-sale or held-to-maturity securities)
- Equity method investments including joint ventures
- Loans payable
- Debt payable
- Guarantees 21
- Firm commitments that do not qualify as derivatives but involve only financial instruments (e.g. a forward purchase contract for a loan that is not readily convertible to cash. That commitment involves only financial instruments--a loan and cash--and would not otherwise be recognized because it is not a derivative instrument.)
- Written loan commitments that do not qualify as derivatives
- The rights and obligations under an insurance contract or a warranty to provide goods or services rather than a cash settlement but whose terms permit the insurer or warrantor to settle by paying a third party to provide those goods or services
- A host financial instrument resulting from the separation of an embedded non-financial derivative instrument from a non-financial hybrid instrument. An example of such a non-financial hybrid instrument is an instrument in which the value of the bifurcated embedded derivative is payable in cash, services, or merchandise but the debt host is payable only in cash.
The fair value option cannot be elected for the following items:
- Deposit liabilities, withdrawable on demand
- An investment in a consolidated entity (a subsidiary or a Variable Interest Entity)
- Net funding position (liabilities or assets) for pension benefits and other post-employment benefits plans
- Obligations or assets for employee stock option and stock purchase plans and other forms of deferred compensation arrangements
- Lease assets or liabilities
- Financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder's equity
3) Investment Companies--For consolidated SPEs that qualify as investment companies under the criteria of the AICPA Audit and Accounting Guide Investment Companies, (Investment Companies Guide), fair value measurement of financial assets is required. If an SPE qualifies as an investment company, then the consolidated financial assets reported by the Bank do not need to be evaluated for classification under FASB ASC Topic 320-10; formerly SFAS No. 115, and no election under FASB ASC Topic 825-10; formerly SFAS No. 159 is necessary. An evaluation of financial liabilities, however, should still be performed to determine if an election under FASB ASC Topic 825-10; formerly SFAS No. 159 is appropriate.
83.03 Fair value measurements
For financial assets (or liabilities) to be reported at fair value, the methods for determining the value prescribed in FASB ASC Topic 820-10; formerly SFAS No.157 should be used. FASB ASC Topic 820-10; formerly SFAS No.157 defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." The best evidence of fair value is the quoted market price in an active market. In the absence of a quoted market price, the Bank should estimate fair value using methods applied consistently and determined in good faith.
FASB ASC Topic 810-10; formerly SFAS No.157 establishes a three-level fair value hierarchy that distinguishes between (a) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (b) the reporting entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs.
Market participant assumptions should include assumptions about the effect of a restriction on the sale or use of an asset if market participants would consider the effect of the restriction in pricing the asset.
83.04 Securities impairments
In this Section:
For securities classified as either available-for-sale or held-to-maturity under FASB ASC Topic 320-10; formerly SFAS No.115, the Bank must determine whether a decline in fair value below the amortized cost basis is other than temporary. For trading securities or securities accounted for at fair value under FASB ASC Topic 825-10; formerly SFAS No.159, unrealized holding losses are included in earnings and, therefore, it is not necessary to evaluate such securities for impairment.
For held-to-maturity securities, each individual security should be evaluated for impairment, and as such, the practice of providing a general allowance for unidentified impairment in a portfolio is not appropriate. If the decline is other than temporary, the cost basis of the individual security should be written down to fair value as a new cost basis, and the amount of the write-down should be included in earnings as a realized loss. The new cost basis should not be changed for subsequent recoveries in fair value. A recovery in fair value should not be recorded in earnings until the security is sold.
FASB ASC Topic 320-10; formerly FSP SFAS 115-1 and SFAS 124-1, describes a three-step process for recognizing an other-than-temporary impairment of investments in accordance with existing literature:
Step 1: Determination of whether an investment is impaired
Generally, an investment is considered impaired if the fair value of the investment is less than its cost. The Bank should determine whether an investment is impaired at the individual security level in each reporting period (except as noted below for certain cost-method investments). FASB ASC Topic 320-10; formerly FSP SFAS 115-1 and SFAS 124-1, describes the "individual security level" as the level of aggregation used by the reporting entity to measure realized and unrealized gains and losses on its debt and equity securities.
FASB ASC Topic 320-10; formerly FSP SFAS 115-1 and SFAS 124-1, also discusses that an investor should not combine separate contracts, such as a debt security and separate guarantee or other credit enhancement, when performing the impairment analysis. A guarantee (or other credit enhancement) should be considered when determining whether an investment is impaired if it (a) provides for payment in a manner that would allow the guarantee to qualify for a scope exception under FASB ASC Topic 815-20; formerly SFAS No. 133, (such as those found in paragraphs 10c or 10d) and (b) is contractually included in the terms of the purchased debt security. Note that accounting for the guarantee separately from the security pursuant to the guidance in FASB ASC Topic 320-10; formerly FSP SFAS 115-1 and SFAS 124-1, may result in the recognition of impairment losses on the security and income statement recognition of the guarantee in different periods.
Step 2: Determination that an impairment is other than temporary
If the fair value of an investment is less than its cost at the balance sheet date, the Bank should determine whether the impairment is other than temporary. While there are no bright-line tests to determine whether an impairment is other than temporary, the Bank should use judgment and consider all available facts in determining whether an impairment is other than temporary. FASB ASC Topic 325-40; formerly EITF No. 99-20 requires the Bank to consider whether there is an adverse change in expected cash flow to determine whether the impairment is other than temporary. The Bank should follow a systematic approach to consider the nature of the impairment of each security with detailed documentation supporting its decision.
In accordance with FASB ASC Topic 320-10; formerly SFAS No. 115, the Bank should consider the following positive and negative factors to determine whether impairment is other than temporary:
a. Positive Evidence--If an investment's fair value declines below cost, the investor must determine whether there is adequate evidence to overcome the presumption that the decline is other than temporary. Such evidence may include the following:
- Increases in fair value subsequent to the balance sheet date
- The investee's stable or improving financial performance and near-term prospects (as indicated by factors such as earnings trends, dividend payments, asset quality, and specific events)
- The financial condition and prospects for the investee's geographic region and industry
b. Negative Evidence--The positive factors must be weighed against any negative evidence that is gathered about the security. The SEC has noted in its staff accounting bulletins and various enforcement releases a number of factors and circumstances that, individually or in combination, may indicate that the Bank needs to write down a security's carrying amount by way of a charge to income. Some of those factors and circumstances are as follows:
- A prolonged period during which the fair value of the security remains at a level substantially below the investor's cost
- The investee's deteriorating financial condition and a decrease in the quality of the investee's assets, without positive near-term prospects (e.g., adverse changes in key ratios and/or factors, such as the current ratio, quick ratio, debt/equity ratio, the ratio of stockholders' equity to assets, return on sales, and return on assets; with respect to financial institutions, examples of adverse changes also include large increases in nonperforming loans, repossessed property, and loan charge-offs)
- The investee's level of earnings or the quality of its assets is below that of the investee's peers
- Severe losses sustained by the investee in the current year or in both current and prior years
- A reduction or cessation in the investee's dividend payments
- A change in the economic or technological environment in which the investee operates that is expected to adversely affect the investee's ability to achieve profitability in its operations
- Suspension of trading in the security
- A qualification in the accountant's report on the investee because of the investee's liquidity or due to problems that jeopardize the investee's ability to continue as a going concern
- The investee's announcement of adverse changes or events, which may include changes in senior management, salary reductions and/or freezes, elimination of positions, sale of assets, or problems with equity investments
- A downgrading of the investee's debt rating
- A weakening of the general market condition of either the geographic area or industry in which the investee operates, with no immediate prospect of recovery
- Factors, such as an order or action by a regulator, that (1) require an investee to (a) reduce or scale back operations or (b) dispose of significant assets or (2) impair the investee's ability to recover the carrying amount of assets
- Unusual changes in reserves (such as loan losses, product liability, or litigation reserves), or inventory write-downs due to changes in market conditions for products
- The investee loses a principal customer or supplier
- Other factors that raise doubt about the investee's ability to continue as a going concern, such as negative cash flows from operations, working-capital deficiencies, or noncompliance with statutory capital requirements
c. Other Factors--FASB ASC Topic 250; formerly SAB No. 99 provides the following factors when evaluating whether a write-down of an investment's carrying amount is required:
- The duration and extent to which the market value has been less than cost
- The financial condition and near-term prospects of the issuer, as well as underlying factors such as specific events or circumstances that may influence the operations of the issuer, including (a) changes in technology that may impair the earnings potential of the investment and (b) the discontinuance of a segment of the business that may offset future earnings potential
- Whether the holder has the ability and intention to retain its investment for a period that will be sufficient to allow for any anticipated recovery in the security's market value
When the Bank has decided to sell an impaired held-to-maturity security and the investor does not expect the fair value of the security to recover fully prior to the expected time of sale, the security should be deemed other than temporarily impaired in the period in which the decision to sell is made. In situations where the Bank sells a security at a loss subsequent to the balance sheet date but before issuance of the financial statements, the Bank should assess whether an other-than-temporary impairment existed at the balance sheet date. Selling securities at a loss subsequent to the balance sheet date, but before issuance of the financial statements, is a strong indicator that an other-than-temporary impairment existed at the balance sheet date. The closer to the end of a previous reporting period that a security is sold at a loss, or the larger the number of sales of such securities, the greater the weight of evidence needed to support a conclusion that an other-than-temporary impairment did not exist at the balance sheet date.
Step 3: Measurement of the other-than-temporary impairment
If an impairment of a security is considered other than temporary, an impairment loss equal to the difference between the cost and the fair value of the investment, calculated as of the balance sheet date, should be recognized in earnings. The fair value becomes the investment's new cost basis. Subsequent recoveries or reductions in fair value after the balance sheet date should not affect the measurement of the impairment loss at the balance sheet date.
FASB ASC Topic 320-10; formerly FSP SFAS 115-1 and SFAS 124-1 requires that subsequent to the recognition of an other-than-temporary impairment loss for debt securities, an investor shall account for the security as if it was purchased on the impairment measurement date. Banks should apply the accounting requirements in FASB ASC Topic 320-10; formerly FSP SFAS 115-1 and SFAS 124-1 based on the security's new cost basis. That is, a discount or reduced premium would be recorded based on the new cost basis, and future changes in the fair value of an available-for-sale security would be recognized in other comprehensive income until disposal of the security or until another impairment in the security is considered other than temporary.
FASB ASC Topic 320-10; formerly FSP SFAS 115-1 and SFAS 124-1 further notes that the discount or reduced premium recorded for the debt security based on the new cost basis would be amortized over the remaining life of the debt security in a prospective manner based on the amount and timing of future estimated cash flows. Any discount or reduced premium should generally be amortized over the remaining life of the debt security using an effective yield method, except when the timing and amount of cash flows expected to be received is not reasonably estimable. In that case, Banks should follow their existing accounting policy for reporting income on securities that are placed on non-accrual status (e.g., cost recovery method).
This paragraph provides guidance determine whether certain commitments fall within the scope of FASB ASC Topic 460-10; formerly FIN No. 45, and how and when to account for a guarantee. While legally a loan commitment, for accounting purposes guarantees are defined in FASB ASC Topic 460-10; formerly FIN No. 45. For those arrangements that qualify as guarantees under FASB ASC Topic 460-10; formerly FIN No. 45, a Reserve Bank may be required to record a liability for the fair value of the obligation it assumes under the guarantee, when the guarantee obligation is established.22
84.02 Definition of guarantees
FASB ASC Topic 460-10; formerly FIN No. 45 defines guarantees in terms of certain characteristics. Transactions with the following characteristics are considered to be guarantees and should be evaluated to determine if an obligation requires recognizing a liability at the time the guarantee is issued:
Contracts that contingently require the guarantor to make payments (either in cash, financial instruments, other assets, or provision of services) to the guaranteed party based on changes in an underlying 23 that is related to an asset, liability, or equity security of the guaranteed party (e.g., financial and market value guarantees). Following are some examples to which this provision applies:
- A financial standby letter of credit, which is an irrevocable undertaking (typically by a financial institution) to guarantee payment of a specified financial obligation.
- A market value guarantee on either a financial asset (such as a security) or a nonfinancial asset owned by the guaranteed party.
- A guarantee of the market price of the common stock of the guaranteed party.
- A guarantee of the collection of the scheduled contractual cash flows from individual financial assets held by a special-purpose entity (SPE).24
- A guarantee granted to a business or its owner(s) that the revenue of the business (or a specific portion of the business) for a specified period of time will be at least a specified amount.
- Contracts that contingently require the guarantor to make payments to the guaranteed party based on another entity's failure to perform under an obligating agreement (performance guarantees).
- Indemnification agreements that contingently require the indemnifying party (guarantor) to make payments to the indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party, such as an adverse judgment in a lawsuit or the imposition of additional taxes due to either a change in the tax law or an adverse interpretation of the tax law.
- Indirect guarantees of the indebtedness of others.
Item 1 above includes most financial standby letters of credit, written put options or market value guarantees on securities (including the common stock of the guaranteed party), and many other financial guarantees. Item 1, however, would not include traditional commercial (non-standby) letters of credit and other loan commitments because they typically do not guarantee payment of an obligation and do not provide for payment in the event of default. Financial standby letters of credit are guarantees because they do not have material adverse change (MAC) clauses or similar provisions that enable the issuing institution (the guarantor) to avoid making a payment. In contrast, many loan commitments contain MAC clauses or other similar provisions that enable the issuing institution to avoid making a loan if the borrower encounters financial difficulties after the commitment is issued.
As an example, if a Reserve Bank provided a guarantee to an entity whereby it would provide loans to that entity if certain asset fair values fell below a predetermined level, the arrangement would probably qualify as a guarantee under FASB ASC Topic 460-10; formerly FIN No.45. Because the arrangement may meet the characteristics described in Item 1 above, recognition of a liability at the issuance of the guarantee would be required. The contract contingently requires the Reserve Bank (guarantor) to make payments to the guaranteed party (in the form of loans) based on changes in the fair value of certain assets (the underlying). More specifically, the guarantee might qualify under Item 1(a), which refers to a standby letter of letter of credit, or Item 1(b), which refers to a market value guarantee.
84.03 Exclusions from guarantees
The scope provisions of FASB ASC Topic 460-10; formerly FIN No. 45 are complex because while certain contracts are fully excluded from its scope, others are excluded from the initial recognition and initial measurement provisions, but are subject to the disclosure provisions.
The following guarantee contracts are fully excluded from the scope of FASB ASC Topic 460-10; formerly FIN No. 45:
- A guarantee or an indemnification that is excluded from the scope of FASB ASC Topic 450-20; formerly SFAS No. 5, including vacation pay, pension costs, deferred compensation contracts, and stock issued to employees.
- A lessee's residual value guarantee in a capital lease under FASB ASC Topic 460-10; formerly SFAS Statement No. 13.
- A guarantee (or an indemnification) whose existence prevents the guarantor from being able to either account for a transaction as the sale of an asset that is related to the guarantee's underlying or recognize in earnings the profit from that sale transaction.
The following types of guarantees are not subject to FASB ASC Topic 460-10; formerly FIN No. 45 for initial recognition and initial measurement, but are subject to its disclosure requirements:
- A guarantee that is accounted for as a derivative instrument at fair value under FASB ASC Topic 815-20; formerly SFAS No. 133.
- A guarantee for which the underlying is related to the performance (regarding function, not price) of nonfinancial assets that are owned by the guaranteed party (e.g., product warranties).
- A guarantee issued in a business combination that represents contingent consideration.
- A guarantee for which the guarantor's obligation would be reported as an equity item (rather than a liability).
- A guarantee issued either between parents and their subsidiaries or between corporations under common control.
- A parent's guarantee of its subsidiary's debt to a third party (whether the parent is a corporation or an individual).
- A subsidiary's guarantee of the debt owed to a third party by either its parent or another subsidiary of that parent.
84.04 Determining when to recognize a guarantee
FASB ASC Topic 460-10; formerly FIN No. 45 requires a guarantor to recognize a liability at the inception of the guarantee. FASB ASC Topic 460-10; formerly FIN No. 45 does not, however, clarify when the inception of a guarantee occurs. FASB ASC Topic 460-10; formerly FIN No. 45 paragraph 3 states that the provisions of the standard apply to guarantee contracts, implying the existence of an enforceable contract. FASB ASC Topic 460-10; formerly FIN No. 45 states "...entering into a contract or agreement that imposes on the guarantor an ongoing obligation to stand ready to perform over the term of the guarantee warrants immediate recognition of a liability for the obligations under the guarantee, even if it is not probable that the specifying triggering events or conditions will occur." This provision includes the word agreement in the definition of a guarantee, whereas paragraph 3 refers only to contracts. In its entirety, FASB ASC Topic 460-10; formerly FIN No. 45 anticipates that a contract or agreement is required to create a guarantee.
Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements (CON 6), paragraph 40 states, "...although most liabilities stem from legally enforceable obligations, some liabilities rest on equitable or constructive obligations. An equitable obligation stems from ethical or moral constraints rather than from rules of common or statute law. A constructive obligation is created, inferred, or construed from the facts in a particular situation rather than contracted by agreement with another entity. Concepts of equitable and constructive obligations must be applied with great care. To interpret them too narrowly will tend to exclude significant actual obligations of an entity, while to interpret them too broadly will effectively nullify the definition by including items that lack an essential characteristic of liabilities."
While FASB ASC Topic 460-10; formerly FIN No. 45 anticipates the existence of a contract or agreement, CON 6 argues that a constructive obligation under a guarantee might exist even without a legally enforceable obligation. The Reserve Banks should evaluate all of the facts and circumstances in evaluating when a guarantee exists. Consider the following in evaluating whether a constructive obligation exists:
- The party's expressed intent to seek a guarantee from a Reserve Bank is not sufficient evidence of the existence of an obligation because there is no indication of agreement among the parties.
- The party's actions that may appear to be in anticipation of Reserve Bank actions, absent any other evidence of agreement between the parties, is not sufficient evidence of the existence of an obligation.
- A statement by a Reserve Bank that it intends to enter into negotiations with the guaranteed party is not sufficient to indicate the existence of an obligation, since the terms would be indefinite at this point.
- A Reserve Bank's past practice of entering into similar transactions with other parties cannot be considered as evidence supporting the existence of a constructive obligation in a new arrangement. Each guarantee arrangement is a stand-alone transaction that should be separately evaluated on its merits by the Reserve Bank.
- Express actions or statements by authorized Reserve Bank representatives that would reasonable lead to an expectation on the part of the party such that the party acts on the expectations might provide evidence that a constructive obligation exists.
- A joint statement of the Reserve Bank and the guaranteed party that includes important terms of the guarantee might provide evidence that a constructive obligation exists.
- A term sheet that is agreed to by all parties provides evidence of a constructive and possibly a legal obligation.
If an obligation under a guarantee existed at the balance sheet date, a liability should be recorded in accordance with FASB ASC Topic 460-10; formerly FIN No. 45. If, subsequent to the balance sheet date but before the issuance of the financial statements, additional information becomes available that affects the obligation that existed at the balance sheet date, the obligation should be adjusted on the balance sheet. If an obligation under a guarantee is material and is issued after the balance sheet date but before the financial statements are issued, the Bank should disclose the guarantee as a subsequent event.
84.05 Initial measurement of a guarantee
When the guarantee obligation is established, the guarantors should recognize a liability equal to the fair value of the guarantee on their financial statements under FASB ASC Topic 460-10; formerly FIN No. 45. If at the inception of the guarantee, it is not probable that a triggering event will occur, then no liability is necessary under FASB ASC Topic 450-20; formerly SFAS No. 5. In the unusual circumstance that it is probable that a liability will occur, a FASB ASC Topic 450-20; formerly SFAS No. 5 contingent liability should be recognized. In such a situation, the liability to be initially recognized for the guarantor's obligation under the guarantee shall be the greater of (a) FASB ASC Topic 460-10; formerly FIN No. 45 guarantee liability at fair value or (b) FASB ASC Topic 450-20; formerly SFAS No. 5 contingent liability. There are two primary approaches for initially measuring the fair value of the guarantee obligation under FASB ASC Topic 460-10; formerly FIN No. 45:
- When a guarantee is issued in a stand-alone arm's-length transaction with an unrelated party and explicit consideration is received, the liability recognized at the inception of the guarantee should be the premium received or receivable by the guarantor.
- When a guarantee is issued as part of a multiple element transaction with an unrelated party (such as in conjunction with selling an asset or entering into an operating lease), the liability recognized at the inception of the guarantee should be an estimate of the fair value of the guarantee. In that circumstance, guarantors should consider the premium that would be required by the guarantor to issue the same guarantee in a stand-alone arm's-length transaction with an unrelated party. In the absence of observable transactions for identical or similar guarantees, expected present value measurement techniques will likely provide the best estimate of fair value.
Generally, because of the unique nature of most guarantees, few are valued based upon "observable transactions for identical or similar transactions." The valuation of most guarantees, therefore, will require the use of fair value estimates.
With respect to estimating fair value, FASB emphasizes that the fair value of a guarantee at inception is not equal to the guarantor's single best estimate of what it will be required to pay under the guarantee. It has further clarified that the notion of fair value contemplates the range of probabilities and potential payments that could be required under the guarantee, not merely a point estimate of the most likely outcome.
FASB ASC Topic 460-10; formerly FIN No. 45 does not prescribe specific accounting for the guarantor's offsetting entry when it recognizes a guarantee liability. That offsetting entry depends on the circumstances in which the guarantee was issued, as illustrated in FASB ASC Topic 460-10; formerly FIN No. 45:
- If the guarantee were issued in a stand-alone transaction for a premium, the offsetting entry would be the consideration received (such as cash or a receivable).
- If the guarantee were issued in conjunction with the sale of assets, a product, or a business, the overall proceeds (such as the cash received or receivable) would be allocated between the consideration being remitted to the guarantor for issuing the guarantee and the proceeds from the sale. That allocation would affect the calculation of the gain or loss on the sale transaction.
- If the guarantee were issued in conjunction with the formation of a partially owned business or a venture accounted for under the equity method, the recognition of the liability for the guarantee would result in an increase to the carrying amount of the investment.
- If a guarantee were issued to an unrelated party for no consideration on a stand-alone basis (that is, not in conjunction with any other transaction or ownership relationship), the offsetting entry would be to expense.
In most cases, the Reserve Banks enter into agreements accounted for as guarantees for no consideration. In these cases, the fourth situation listed above would be applicable, and the Banks should charge the initial obligation to profit and loss (FR 34 Account 330-100).
84.06 Subsequent measurement of a guarantee
Subsequent to initial measurement, the accounting would depend on the nature of the guarantee and how the Reserve Bank (guarantor) is released from risk. FASB ASC Topic 460-10; formerly FIN No. 45 provides three possible approaches to the subsequent accounting for the guarantee:25
- Marking the guarantee to fair value at each balance sheet date, so long as the guarantee remains outstanding
- Leaving the guarantee at its original amount until either expiration or settlement of the guarantee
- A systematic and rational amortization of the value of the guarantee to income over the period of the guarantee.
If the guarantee issued by a Reserve Bank is based on a change in an underlying, such as a change in the fair value of certain assets of the guaranteed party (market value guarantee), then the subsequent measurement of the liability should be based on marking the guarantee to market at each balance sheet date. This approach is especially relevant if the obligation was initially measured using a fair value approach. If a fair value approach is not feasible, then the value of the guarantee may be amortized over the period of the guarantee in a systematic and rational manner.
Any residual liability that remains at the termination of the guarantee should be recorded to profit and loss in the period of the termination. For a guarantee whereby the Reserve Bank agrees to make loans to the guaranteed party based on the occurrence of a future event, the period of the guarantee expires when the maximum amount of loans required under the guarantee have been extended.
The Reserve Bank must disclose the following information about each guarantee, or each group of similar guarantees in its annual financial statements, even if the likelihood of having to make any payments under the guarantee is remote:
- The nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the Reserve Bank to perform under the guarantee.
- The maximum potential amount of undiscounted future payments the Reserve Bank could be required to make under the guarantee. That maximum potential amount of future payments shall not be reduced by the effect of any amounts that may possibly be recovered under recourse or collateralization provisions in the guarantee. If the terms of the guarantee provide for no limitation to the maximum potential future payments under the guarantee, that fact shall be disclosed. If the Reserve Bank is unable to develop an estimate of the maximum potential amount of future payments under its guarantee, it shall disclose the reasons why it cannot estimate the maximum potential amount.
- The current carrying amount of the liability, if any, for the Reserve Bank's obligations under the guarantee (including FASB ASC Topic 450-20; formerly SFAS No. 5 contingency liability), regardless of whether the guarantee is freestanding or embedded in another contract.
- The nature of (1) any recourse provisions that would enable the Reserve Bank to recover from third parties any of the amounts paid under the guarantee and (2) any assets held either as collateral or by third parties that, upon the occurrence of any triggering event or condition under the guarantee, the Reserve Bank can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee. The Reserve Bank shall indicate, if estimable, the approximate extent to which the proceeds from liquidation of those assets would be expected to cover the maximum potential amount of future payments under the guarantee.
- The method used for subsequent accounting for the guarantee and an explanation of why the method chosen is appropriate for the guarantee.
3. As defined for accounting purposes in accordance with FASB ASC Topic 460-10; formerly FIN No. 45. This may differ from the legal definition of a guarantee. See paragraph 84.01 for further discussion on Guarantees. Return to text
4. Collateral value method does not apply to loans with recourse. Present value of expected cash flows or market price methods are more representative of the impairment since the lender has recourse to additional assets of the borrower. Return to text
5. The percentage of loans (%) expected to default, multiplied by the loss per loan (%) applied to the dollar value ($) of the total loans outstanding. Return to text
6. Default occurs when the debtor cannot pay all or some of the amounts due according to the contractual terms of the loan agreement, including contractual principal and contractual interest amounts. Return to text
7. Exposure at default includes total investment including principal, interest, and unamortized fees. Return to text
8. ‘Generally sound' refers to institutions that are CAMELS 1, 2, or 3 and are at least adequately capitalized. At the discretion of the Reserve Bank, however, institutions that otherwise meet these criteria may be deemed ineligible for primary credit because of the significance of supplementary information regarding an institution's financial condition. Return to text
9. Institutions that are not in generally sound condition are CAMELS 4 or 5, less than adequately capitalized, or are rated CAMELS 1, 2, or 3 but the Bank is aware of the significant supplemental adverse information regarding the institution's financial condition. Return to text
10. Seasonal credit may be extended to institutions that are CAMELS 1, 2, 3, or 4 and are at least adequately capitalized. At the discretion of the Reserve Bank, however, institutions that otherwise meet these criteria may be deemed ineligible for seasonal credit because the Bank is aware of significant supplementary adverse information regarding an institution's financial condition. Return to text
11. To calculate the collateral (lendable) value, a margin is applied to either the market price of the securities or the theoretical price of assets that do not receive market values. Market prices are used as the basis for collateral valuation whenever active markets exist. Market prices are obtained from a vendor that prices CDOs and another vendor that prices all other types of securities and updates the prices frequently. If the Reserve Bank is unable to obtain a market price for pledged assets (e.g., consumer loans) from its vendor(s), a theoretical price is calculated for asset categories based on various characteristics of the asset type, including credit quality, interest rate, maturity, liquidity, and the current interest rate environment. A margin is then applied to the theoretical price. Return to text
12. Transitional credit extensions, part of the PDCF facility, are to the U.S.- and London-based broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley, and Merrill Lynch through PDCF, announced September 21, 2008. Return to text
13. FASB ASC Topic 450-20; formerly SFAS No. 5 defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Return to text
14. As defined for accounting purposes in accordance with FASB ASC Topic 460-10; formerly FIN No.45. This may differ from the legal definition of guarantee. Return to text
15. Special purpose entities are legal entities created to fulfill narrow, specific, or temporary objectives. An SPE typically limits the recourse of its creditors to the net assets of the SPE and as a result, the creditors do not have recourse to the general credit or assets of the SPE's beneficiaries. Return to text
16. Consolidated statements present the results of operations and the financial position of a Reserve Bank and its SPEs essentially as if the group were a single enterprise. Return to text
17. A controlling financial interest is the ability to direct or cause the direction of the management and policies of an enterprise through ownership or other financial interests. Return to text
18. A business is defined as a self-sustaining integrated set of activities and assets conducted and managed for the purpose of providing a return to investors. A business consists of (a) inputs, (b) processes applied to those inputs, and (c) resulting outputs that are used to generate revenues. For a set of activities and assets to be a business, it must contain all of the inputs and processes necessary for it to conduct normal operations, which include the ability to sustain a revenue stream by providing its outputs to customers. All entities, except those defined in paragraph 4(a)-(h) of FASB ASC Topic 810-10; formerly FIN No. 46(R), must be evaluated. Exceptions include not-for-profit organizations, employee benefit plans, health insurance entities, and governmental organizations; other GAAP literature should be used to determine if consolidation is required for these entities. Return to text
19. Although use of the guidance in FASB ASC Topic 946-10; formerly SOP 07-1 was not adopted by the American Institute of Certified Public Accountants (AICPA), it presents helpful additional guidance that is not included in the Audit Guide. Return to text
20. Account for derivatives in accordance with FASB ASC Topic 815-20; formerly SFAS No. 133. Return to text
21. As defined for accounting purposes in accordance with FASB ASC Topic 460-10; formerly FIN No. 45. This may differ from the legal definition of a guarantee. See paragraph 84.01 for further discussion on Guarantees. Return to text
23. An underlying is defined in FASB ASC Topic 815-20; formerly SFAS No. 133 as a specified interest rate, security price, commodity price, foreign exchange rate, index of prices, or other variable. The occurrence or nonoccurrence of a specified event is a variable that is considered an underlying under that definition. Return to text
25. The subsequent measurement of a guarantee liability under FASB ASC Topic 460-10; formerly FIN No. 45 discussed here does not encompass (and therefore, is separate from) the recognition and subsequent adjustment of the contingent liability under FASB ASC Topic 450-20; formerly SFAS No. 5 relating to the contingent loss for the guarantee. FASB ASC Topic 460-10; formerly FIN No. 45 in general requires the recognition of a guarantee liability in an earlier stage when it is not probable that the triggering events will occur (and therefore, a FASB ASC Topic 450-20; formerly SFAS No. 5 contingent liability will not be recognized). When it becomes probable that a liability will be incurred, a FASB ASC Topic 450-20; formerly SFAS No. 5 contingent liability needs to be assessed and the greater of (a) FASB ASC Topic 460-10; formerly FIN No. 45 guarantee liability at fair value or (b) FASB ASC Topic 450-20; formerly SFAS No. 5 contingent liability should be recorded. Return to text