Speech by SEC Staff:
Remarks before the 2010 AICPA National Conference on Current SEC and PCAOB Developments
Lisa D. Watson
Professional Accounting Fellow
U.S. Securities and Exchange Commission
December 6, 2010
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect those of the Commission or of the author’s colleagues upon the staff of the Commission.
Good morning. Today I’d like to talk about two things that I’ve spent some time working on recently, both of which relate to how to account for involvement with assets when they’re not held in separate legal entities.
Accounting for foreclosed real estate involving loan participations
In our office, we become aware of accounting issues in a variety of ways, one of which is through our regular interactions with other regulatory agencies. In the past few months, we’ve spent some time talking to the banking regulators about the accounting by banks when they foreclose on the real estate collateralizing a loan, if a participation interest in that loan had been transferred to one or more other banks.
By way of background, loan participations occur when a borrower wants a loan that’s bigger than a bank is comfortable lending, which might happen, for example, with a large commercial real estate loan. When this happens, a bank — called the Lead Bank — can originate the loan and then transfer an undivided interest in the loan to another bank — called the Participating Bank. If the criteria for sale accounting are met, the Lead Bank accounts for this type of transaction as a sale and derecognizes the portion of the loan that was transferred.1 So, a Lead Bank that participated out a 40% interest and retained 60% would keep 60% of the loan on its books, and the Participating Bank would record 40% of the loan on its books.
Now let’s discuss what we’ve observed in the current environment. Some of the borrowers in loan participations have defaulted. When a default occurs and the underlying real estate is foreclosed, an entity such as a limited liability company might be established to take title to the real estate or title might be taken without use of a separate legal entity. The issue raised to our office was how banks should account for their pro-rata share of the foreclosed real estate when a separate legal entity is not formed to hold title.
The question of how to account for a shift in the unit of account from a financial instrument to real estate requires careful analysis. For example, should the Lead Bank put the whole property on its books with a liability to the Participating Bank for its share? Or should each bank account for its interest using the equity method? Or should each bank report its pro-rata share in the real estate, like they had accounted for the loan before the foreclosure?
In discussing this issue, we observed two things. First, that legal title may be held in a variety of ways and, second, there are not standard contractual terms for participation agreements. An understanding of all terms of the arrangement, including the rights and obligations of the Lead Bank and the Participating Bank(s), is critical to any accounting conclusion. Therefore we don’t believe that there’s a blanket conclusion that can be applied under the current accounting standards. But I can share with you some of the factors that we spent time considering in hopes that they would be useful to you in your analysis.
The accounting guidance for involvement with real estate includes guidance for when real estate is held through corporate joint ventures, partnerships, and undivided interests.2 If the foreclosed real estate isn’t held in one of these forms, then the general guidance on real estate may not be applicable. In that case, some analogies might be drawn.
Depending on the facts and circumstances, one way to evaluate the transaction may be focused entirely on the manner in which title is held. With foreclosed real estate, the manner in which title is held depends on both the contractual terms of the participation agreement and the applicable law, which varies from jurisdiction to jurisdiction. For example, the contract may permit title to be held by the banks as tenants in common, in trust for benefit of the banks, or by the Lead Bank in its name individually.
Again depending on the facts and circumstances, another way to evaluate the transaction may be through the principles in the general guidance on accounting for involvement with real estate. To start with, to be considered an undivided interest within the scope of the real estate guidance, title must be held individually to the extent of each party’s interest.3 Thus, the manner in which title is held is one factor under the general real estate guidance.
The ability to make decisions and the extent of each bank’s exposure to economic risks and rewards can also be key factors in determining the appropriate accounting under the general real estate guidance, both when real estate is and is not held in a separate legal entity.4 Sometimes a bank’s right to participate in making decisions about significant financings, development, sale, or operations is viewed as a protective right. But when real estate is owned due to foreclosure, the decisions to be made might be expected to be fairly limited, especially in light of regulatory constraints on the ability of banks to hold Other Real Estate Owned. As a result, the extent of each bank’s rights to participate in those types of decisions may be of particular importance.
In addition to the guidance for real estate in general, accounting guidance is also provided for sales of real estate. Like the guidance for transfers of financial assets, the guidance for sales of real estate permits recognition of partial sales of real estate if certain conditions are met. By analogy, then, when those conditions are met, it might make sense in some cases to account for an interest in foreclosed real estate in a manner that continues to give effect to the previous partial sale.
I would also like to point out that the Emerging Issues Task Force is currently addressing the issue of when an investor should deconsolidate a subsidiary that is in-substance real estate5. The EITF recently decided to form a working group to address questions related to the issue, which may include not only questions about derecognition of real estate by an investor, but also recognition of real estate by a lender. Our views will continue to be informed by the EITF’s efforts.
Derecognition For Transfers Of Businesses Not In Legal Entities
The question of how to think about a transaction when there’s no legal entity involved has also arisen in some other contexts. Over the years, my colleagues in OCA have shared with you their views about whether the inclusion of a legal entity could enable a company to bypass accounting guidance for derecognition of assets, particularly financial assets. Recently, we became aware of a situation that raised the inverse concern. That is, whether the lack of a legal entity could enable a company to bypass accounting guidance for derecognition of assets.
In this situation, a registrant transferred one of its businesses to a third party. As part of the arrangement, the third party was given the right to sell the business back to the registrant in the future for the same amount the business was worth at the date of the initial transaction. Prior to that option becoming exercisable, the registrant would continue to operate the business under a management agreement. The financial impact of the management agreement was that the registrant retained the risks and rewards of cash flows of the business while serving as the manager. If the put option is exercised in the future, the business will come back to the registrant. If the put option is not exercised, the registrant has the unilateral right to extend the management agreement for several more years.
In this case, the business that was transferred by the registrant was not held in a separate legal entity. The registrant’s analysis of whether the business should be derecognized consisted of analyzing whether the registrant should consolidate the third party to which the business was transferred. Once they concluded that they shouldn’t consolidate the third party, they derecognized the business and recognized a gain on the sale.
We questioned whether there was a step that was overlooked. Namely, the step assessing whether it would be appropriate to derecognize the business, even if the registrant didn’t consolidate the acquirer. Our concern was that if this assessment was not made, then any time a business is transferred to a third party without being housed in a separate legal entity, that business would be derecognized — and a gain or loss recognized — regardless of the nature and extent of continuing involvement. This doesn’t seem consistent with the conceptual underpinning of Accounting Standards Update 2010-2, which is that a transfer of real estate, financial assets, or a group of assets constituting a business should not receive different accounting treatment when the assets are in a legal entity than when they are not. The guidance in the ASU indicates that a group of assets that is a business should be derecognized when the parent ceases to have a controlling financial interest in that group of assets. We believe this requires looking not only at whether the acquirer should be consolidated, but also looking at whether there has ceased to be a controlling financial interest over the particular business that was transferred.
That concludes my prepared remarks. Thank you for your time.
1 The criteria for sale accounting are in ASC Topic 860, Transfers and Servicing.
2 This guidance is primarily located in ASC Topic 970, Real Estate — General, and in ASC Subtopic 360-20, Property, Plant, and Equipment — Real Estate Sales.
3 See ASC 970-323-05-2 and ASC 970-323-20.
4 See ASC 970-323-25.
5 EITF Issue 10-E, Accounting for Deconsolidation of a Subsidiary That Is In-Substance Real Estate