A Platform to Debate Accounting
Kyle Richard and Melissa Kosiba
2005 - Securitization is defined as a method of hedging financial
bets by bundling assets and selling bonds backed by current
and future revenue from these assets. More simply, securitization
is the process of converting assets, most commonly accounts
receivables, into marketable securities. Corporations use
this method primarily to raise fast cash. Rater than recognizing
revenue over the long term (e.g., as receivables are amortized),
companies sell bundled assets as bonds backed by both the
receivable and its corresponding collateral. Companies also
use securitization to control annual income. If regular accounts
receivable payments produce an adequate annual income, securitization
is typically avoided. If such income is inadequate, assets
will be sold so that the long-term revenue can “pull
forward,” or be recognized during the current fiscal
securitization market began in the early 1970s with the
issuance of bonds backed by mortgage loans. Previously,
the U.S. government had subsidized the mortgage industry
by offering tax breaks to mortgage companies. Unlike banks,
which can draw on liquid deposits when funds are needed
quickly, companies that focus on lending have no way to
raise quick capital. The only revenue such companies generate
is through closing costs and amortized monthly payments.
So, in the early 1970s, the government created secondary
mortgage markets like the Federal Home Loan Mortgage Corporation
(Freddie Mac) and the Federal National Mortgage Association
(FNMA, or Fannie Mae) to give mortgage companies a way to
increase the liquidity of their business, especially during
1975, shortly after the development of a secondary mortgage
market, Sperry Corporation decided to securitize its computer
lease receivables. The market spread like wildfire. Car
loans were securitized beginning in the early 1980s. Over
a short span of about 20 years, the secondary securities
market has grown into a billion-dollar industry.
securitization industry has two categories. The first is
mortgage-backed securities (MBS), which groups together
first-mortgage loans, termed home-equity loans, home-equity
lines of credit, and tax liens placed on residential property.
The second type encompasses all other receivable assets,
including automobile loans, outstanding credit card balances,
student loans, small-business loans, lawsuit settlements,
and future revenue generated by royalties. The kinds of
assets that can be securitized are broad. In 2004 the outstanding
issuance of securities totaled seven trillion dollars. Growth
for 2005 is estimated at an astounding $750 billion.
mechanics of the securitization process are simple. The
originator pools together a diverse group of receivables
of varying durations, maturities, interest rates, and risk
ratings, and moves them to a special purpose entity (SPE),
or trust, established by the originator for this specific
purpose only. The SPE, in turn, issues asset-backed securities
(ABS) or MBSs, depending on the collateral corresponding
to the receivable to investors on the open market. The ABS/MBS
is divided into different classes (Class A, B, Z), which
dictate the priority of repayment.
the receivable security is removed from the balance sheet
of the originator to a SPE, the asset value does not change.
Once the security is issued by the SPE, the asset will increase
in value. This is because the assets of the originator are
worth more outside the company, to investors, than within
it. It is crucial for the originator to know the relationship
between external and internal value before entering into
the SPE receives the asset from the originator, the asset
is immediately considered off–balance sheet, and,
therefore, bankruptcy-remote. Being “bankruptcy remote”
protects the asset from the creditors of the originator.
In the event of a bankruptcy, the assets would be protected
from the bankruptcy estate. SPEs are sometimes termed BRSPE
to emphasize this point. When the originator has received
capital for its ABS/MBS, it will use the funds to originate
new loans or to pay down existing unsecured debt.
that securitize assets derive several benefits. First, the
asset is removed from the balance sheet. This allows for
recognition of the gain or loss immediately, intentionally
improving the originator’s current-year operating
results. Second, the use of securitization reduces reliance
on unsecured debt, specifically commercial paper. Third,
it increases liquidity. Securitization is accepted as a
low-cost/low-risk method of financing.
specifically at the automotive industry, securitization
has become the preferred method of raising capital. The
credit ratings of North American automotive companies are
too low to issue unsecured debt that would be beneficial;
their poor rating would make this type of debt extremely
expensive. Therefore, the captive finance companies, specifically
General Motors Acceptance Corporation (GMAC) and Ford Motor
Credit Corporation (FMCC), pool vehicle loans and sell them
on the open market as ABSs. The securities are deemed “safe
investments,” as both the vehicle loan and its collateral
back the security bond.
benefits to investors purchasing ABSs or MBSs are superior
rates of return, event risk reduction, diversification,
and increased liquidity. The securities are rated by credit
rating agencies such as Standard & Poor’s and
Moody’s. The biggest potential benefit is that the
investor is assured that there is an actual tangible asset
behind the security. In the case of automotive securities,
the tangible assets are the vehicles and the vehicle loans.
of the Securitization Market
the securitization market has grown, accounting standards
have developed. In late 2000, FASB issued a new accounting
standard to govern securitization, SFAS 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities. SFAS 125, Accounting for Transfer
and Servicing of Financial Assets and Extinguishment of
Liabilities, remained intact with the issuance of SFAS
140, but SFAS 140 made more specific provisions to dictate
the origination and handling of SPEs, and FASB increased
the amount of disclosure required by companies using the
secondary securities market. SFAS 140 requires very specific
disclosure of securitization and the reasons for securitization
in all corporate financial statements, to ensure that securitization
is not abused or in some way skewing the financial image
of a corporation.
140 creates a framework for securitization. According to
this standard, assets that are to be securitized must be
isolated beyond the transferor (or originating company)
and its creditors. As mentioned previously, emphasis is
placed on the creditors of the transferor to protect the
securitized assets in the unfortunate event of a bankruptcy.
By isolating the assets from the creditors, they are saved
from the potential bankruptcy estate. In addition, the transferee
(or buyer) receives full rights to do with the assets as
it wishes. The transferor retains no control over the securitized
assets. SFAS 140 establishes conditions for the transfer
of the securitized assets, and includes considerations for
140 follows the current system of rules-based accounting
standards. Specific criteria, or “bright-line”
rules, are given that lay out the requirement to be met
for a sale of assets to qualify as an off–balance
sheet securitization. If the sale meets the criteria, then
it can be removed from the corporate balance sheet and replaced
with cash. If the sale fails just one criterion, then it
must remain on the corporate balance sheet and its revenue
will be recognized over the term of the receivable or the
lifetime of the asset. Critics of the current rules-based
system point out that accounting standards such as this,
which generate a checklist of criteria for accountants and
CFOs, are more concerned with the form of the accounting
transaction. Critics claim that little attention is paid
to the substance of the transaction, or to how the transaction
affects the overall financial status of the company.
are many reasons why principles-based accounting standards
would be logical. First, they force companies to focus on
the substance of the economic event, reducing opportunities
to focus on form and, in turn, ignore the function of the
transaction. Second, the principles would be more broadly
based than the existing U.S. rules-based standards. The
new system would require fewer, if any, exceptions, and
would limit the need for implementation guidance. Instead
of the 100-plus pages currently needed to explain current
standards, principles-based standards might be as little
as 12 pages long. A principles-based system would also increase
the need for professional judgment, meaning that the preparer
and the auditor would be held to a higher standard. Both
parties would be focused not on checklists of accounting
criteria, but on the substance of the transaction and the
impact of securitization. Finally, principles-based standards
would help avoid potential double-jeopardy issues that both
preparers and auditors currently face with regard to the
lack of detailed information.
greatest negative impact of implementing a principles-based
accounting standard is that the comparability between financial
statements could be reduced because of varying interpretations.
Investors would face greater difficulties as investment
opportunities arose. The financial statements would be more
grounded in the value of various transactions, but at times
investors would be forced to undertake considerable research
when making investment decisions. Furthermore, enforcement
would be challenging. Additionally, principles-based standards
would require a large number of disclosures in financial
statements. The cost incurred during the change from the
current rules-based standards might also be a deterrent.
Accounting firms and publicly traded companies would likely
challenge the change from a legal perspective, resulting
in costly attorney fees and drawn-out litigation.
International Accounting Standards Board (IASB) has done
a creditable job of creating order from chaos. Because the
IASB operates on a “risk-over-rewards” concept,
the countries that operate under the IASs have not experienced
the level of accounting scandals that the U.S. has seen
under FASB. The risk-over-rewards principle enacted by the
IASB states that if the seller is absorbing the risk, then
the seller receives the reward. Conversely, if the buyer
assumes the risk, than the buyer benefits from the potential
principles-based standards would improve the quality and
transparency of financial reporting between a U.S.-based
company and a foreign-based company. Such a change would
show that the United States is prepared to focus on a global
its lifetime, securitization has stimulated fierce debate.
Because of its ability to manipulate income, corporations
have, at times, abused securitization to improve their overall
financial image. Enron was not the first company to hide
its debt through securitization. In the early 1990s, less
than 20 years after the invention of securitization markets,
a greeting-card company used securitization to hide its
failing financial health. Five years later, a small investment
company was also caught red-handed using the securitization
market to camouflage its financial problems.
was, however, the most visible abuse in the history of securitization.
Enron used SPEs to hide liabilities from creditors and investors
alike. The SPEs in question met the criteria established
by SFAS 140. Supporters of principles-based accounting cite
Enron as an example of the AICPA’s Accounting Standards
Board’s placing more emphasis on form than on substance.
Despite their compliance in form, the substance of these
SPEs effectively hid the financial failings of the corporation.
Enron collapsed, FASB has fought to focus attention on substance.
In addition, the Sarbanes-Oxley Act of 2002 (SOA) increased
corporate governance and the responsibilities of auditors.
Internal audits are no longer the isolated responsibility
of a specific department within a corporation. With SOA,
audit committees must now be established and corporate officers
must sign off on audits, vouching that the audit realistically
expresses the health of the corporation. In December 2003,
FASB also issued Interpretation 46, which addresses criteria
for SPEs. This interpretation is principles-based in concept,
as it focuses on the substance of the entity: who owns a
majority interest and how the entity changes the financial
picture of the company.
is no easy way to account for securitization. Because it
is such a powerful tool for controlling income and cash
flow, it is highly susceptible to abuses. Rules-based accounting
standards tend to focus on the format of the transaction
rather than on how the transaction changes the overall financial
picture. However, rules-based standards are accompanied
by implementation guidance and specified exceptions that
dictate how transactions are handled. Auditors and accountants
must use professional judgment, but only to a limited extent.
With a principles-based system, although accounting professionals
would be held to a higher standard and more focus would
be placed on substance and on reward/risk observations,
interpretations would vary across entities.
U.S. will probably never move completely to principles-based
accounting standards, due to potential cost and legal issues.
Securitization, however, will continue to grow in popularity
and use, which will result in many future debates over the
handling of these transactions.
Richard is a marketing manager with Volkswagen of
Melissa Kosiba is a personal banker with Republic