FAS facts: what will the AICPA, SEC, and others come up with next��and what does it all mean to you? RMA's ongoing series looks at implications for bankers: SAB No. 105 GAAP and derivatives

SAB No. 105, which talks about applying GAAP to mortgage-loan commitments accounted for as derivative instruments and entered into after March 31, 2004, should help bankers recognize their own and their clients' loan commitments more properly.

Many banks extend commitments to issue mortgages that they intend to sell after funding. In addition, they expect to benefit from future servicing fees and other charges. I n Staff Accounting Bulletin (SAB) No. 105, "Application of Accounting Principles to Loan Commitments," the SEC states its views in applying generally accepted accounting principles to mortgage-loan commitments accounted for its derivative instruments and entered into after March 31, 2004.

Basically, to create better uniformity in accounting practices, the SEC staff reasons as follows:

1. If a bank commits to a loan at a specified rate with the intent to sell the mortgage loan after funding, the commitment is to be regarded as a derivative instrument.

2. The bank cannot consider expected cash flows derived from servicing the loan when treating; the loan commitment as a derivative. Such servicing assets should be recognized only after "the servicing asset has been contractually separated from the underlying loan by sale or securitization of the loan with servicing retained."

SFAS Nos. 133 and 149 require entities making mortgage-loan commitments to record them on the balance sheet at fair value, but they do not address how to measure the fair value for the loan commitment. SAB No. 105 requires that fair-value measurement include only differences between the guaranteed interest rate in the loan commitment and a market interest rate, excluding any expected future cash flows related to the customer relationship or loan servicing. Hence, banks should determine the fair value of the loan commitment based solely on the relationship to market interest rates.

SAB No. 105 obviously will limit opportunities for banks to recognize some assets. Previously, banks that initially recognized the loan commitment and included cash flows related to servicing rights in fair-value measurements may have reported gains or revenue. But under the new regulation, banks should recognize mortgage-loan commitments as liabilities if, for example, the market interest rate exceeds the guaranteed interest rate of the commitment.

Moreover, instead of recording other internally developed intangible assets (e.g., customer relationship intangible assets) as part of the loan commitment derivative, banks should recognize them only in third-party transactions (e.g., purchase loan commitments individually, in a portfolio, or in a business combination).

Disclosures

SAB No. 105 states that the SEC staff "will not object" if registrants continue to use their existing, nonconforming accounting polices for loan commitments accounted for as derivatives entered into before March 31, 2004, provided they adopt the new provisions after that date.

Registrants should disclose their accounting policy for mortgage-loan commitments accounted for as derivatives, including methods and assumptions used to estimate the fair value of loan commitments in the financial statements. They also should disclose associated hedging strategies to enable investors to understand how the entity manages the risk associated with issuing loan commitments.

Examples

Assume that Bank A enters into a loan commitment with a customer to extend a mortgage loan at a specified rate, which it intends to sell after it is funded. Under SFAS No. 133, Bank A should account for such loan commitments as a derivative instrument, measured at fair value. (1) Bank A expects to receive future cash flows related to servicing rights from servicing fees (included in the loan's interest rate or otherwise), late charges, and other ancillary sources, or from selling the servicing rights into the market.

In recognizing the loan commitment under SAB No. 105, Bank A may not consider expected future cash flows related to the associated servicing of the loan, since that would result in the immediate recognition of a servicing asset. (However, it should recognize servicing assets after such assets are contractually separated from the underlying loan by sale or securitization of the loan with servicing retained. (2)) Furthermore, no other internally developed intangible assets (e.g., customer relationship intangible assets) should be recorded as part of the loan commitment derivative. It should recognize such assets only in a third-party transaction (for example, the purchase of a loan commitment individually, in a portfolio, or in a business combination).

Bank A should disclose its accounting policy for the following:

* Loan commitments pursuant to APB Opinion No. 22, "Disclosure of Accounting Policies."

* Disclosures related to loan commitments accounted for as derivatives, including methods and assumptions used to estimate fair value and any associated hedging strategies. (3)

* Disclosures required by Item 303 of Regulation S-K and any related interpretive guidance.

Summary

Although no actual disclosures of this SEC pronouncement exist as yet, its provisions should provide important tools to help bankers recognize more accurately their own and their clients' loan commitments.

Contact Reinstein by e-mail at a.reinstein@wayne.edu.

Notes

(1) Paragraph 3 of SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, amended paragraph 6(c) of Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, to add: "... loan commitments that relate to the origination of mortgage loans that will be held for sale, as discussed in paragraph 21 of SFAS No. 65, Accounting for Mortgage Banking Activities (as amended), shall be accounted for as derivative instruments by the issuer of the loan commitment (that is, the potential lender)." SFAS No. 133, Implementation Issue No. C13, Scope Exceptions: When a Loan Commitment Is Included in the Scope of Statement 133, provides similar guidance.

(2) See paragraph 61 of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

(3) As required by SFAS No. 107 [Disclosures about Fair Value of Financial Instruments], SFAS No. 133 and Item 305 of Regulation S-K.

[c] 2004 by RMA. Alan Reinstein, CPA, DBA, is George R. Husband Professor of Accounting at the School of Business, Wayne State University, Detroit, Michigan.

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