What Was FAS 140 and Why Was It Replaced?

Financial Accounting Standard 140 (FAS 140) established the accounting rules for transfers of financial assets. It provided a framework for companies to determine if a transfer should be recorded as a sale or as a secured borrowing. This distinction dictates whether the assets are removed from the seller’s balance sheet.

The standard’s core principle was whether the entity transferring the assets had surrendered control over them. This determination provided a path for companies to achieve off-balance-sheet treatment for certain assets, a practice central to securitization.

FAS 140 is no longer the active standard in U.S. Generally Accepted Accounting Principles (GAAP), having been superseded by subsequent standards. Its principles are now incorporated within the FASB Accounting Standards Codification (ASC) Topic 860, Transfers and Servicing.

The Core Principle of Control Surrender

FAS 140 determined whether a company had given up control over transferred financial assets. If control was surrendered, the transaction was a sale; if not, it was a secured borrowing. The standard laid out three conditions that had to be met for sale accounting. Failure to meet even one condition meant the transfer was accounted for as a financing, with the assets remaining on the transferor’s books.

These conditions were designed to ensure the transfer was a permanent disposition of the assets, not a disguised loan. Each condition addressed a different facet of control, from legal finality to the buyer’s ability to use the assets freely.

Legal Isolation

The first condition required that the transferred assets be legally isolated from the transferor. This meant the assets had to be placed beyond the reach of the transferor and its creditors, even in bankruptcy, which required a legal opinion to substantiate.

FAS 140 required a structure, such as a trust, that would legally protect the transferred assets from the seller’s financial troubles. This ensured the buyer’s claim was secure, similar to how items in a safe deposit box are separated from the owner’s personal debts.

Without this legal separation, a purported sale could be unwound in a bankruptcy court. Companies spent considerable effort structuring transactions to satisfy this test of control surrender.

Transferee’s Right to Pledge or Exchange

The second condition required the transferee, the entity receiving the assets, to have the right to pledge or exchange them. This right could not be constrained by any condition providing a more than trivial benefit to the original transferor, ensuring the buyer had the freedom to use the assets.

The buyer needed to be able to use the assets as collateral for its own borrowings or sell them to another party. Significant restrictions, such as preventing the sale of assets to a competitor of the seller, could invalidate sale accounting.

The ability to pledge or exchange the assets gives them economic utility to the new owner. By verifying the transferee possessed these rights without meaningful limitation, FAS 140 confirmed that economic control had shifted from the seller to the buyer.

Absence of Transferor’s Effective Control

The third condition ensured the transferor did not maintain effective control over the transferred assets. This was often violated by an agreement allowing the transferor to repurchase the assets before they matured. If such an agreement effectively forced the transferor to reclaim the assets, control was not surrendered.

For example, a repurchase agreement with a fixed price well below the assets’ expected future value would be so advantageous that it would almost certainly be exercised. This functions like a loan where the assets serve as collateral that will be returned.

This condition prevented companies from recording a sale while retaining the risks and rewards of the assets through a side agreement. The seller could not have a mechanism to unilaterally reclaim the assets and their future cash flows.

The Role of Qualifying Special Purpose Entities

To meet the control-surrender criteria, especially legal isolation, companies used a Qualifying Special-Purpose Entity (QSPE). A QSPE was a trust or other legal vehicle created to hold financial assets and issue securities to investors. Under FAS 140, these entities were designed to be passive.

A QSPE’s activities were strictly limited to those established at its creation. It could hold transferred financial assets, collect cash flows, and distribute them to investors. It was forbidden from making discretionary decisions or actively managing the assets.

The motivation for using a QSPE was to achieve off-balance-sheet accounting for securitized assets. A properly structured QSPE was not required to be consolidated onto the financial statements of the company that created it, which was an exception to standard consolidation rules.

Accounting for Servicing Rights

In many financial asset sales, the seller continues to perform administrative tasks like collecting payments. This activity is known as servicing. The right to perform servicing for a fee creates a servicing asset or servicing liability.

FAS 140 required companies that sold assets but retained servicing obligations to recognize a servicing asset or liability. If the expected fees were more than the cost to service, a servicing asset was recorded. If costs were expected to exceed fees, a servicing liability was recorded.

These servicing rights were initially measured by allocating the assets’ previous carrying amount between what was sold and what was retained, based on their relative fair values at the transfer date. This required estimating the fair value of the new servicing contract.

After initial recognition, companies had two options for subsequent measurement. They could amortize the servicing asset or liability and test it for impairment. Alternatively, they could measure the servicing rights at fair value at each reporting date, with changes in value reported in earnings.

Transition to Current GAAP and ASC 860

The FAS 140 framework came under scrutiny after the 2008 financial crisis. A central issue was the use of off-balance-sheet entities like QSPEs, which allowed institutions to hold significant risks not visible on their financial statements. The crisis revealed that many companies had implicit obligations to support the QSPEs they created, despite no consolidation requirement.

In response, the FASB issued new standards in 2009 that changed the accounting for asset transfers and consolidation. These principles are now located within ASC 860 for transfers and ASC 810 for consolidation.

The most significant change was the elimination of the QSPE concept and its exemption from consolidation. These entities, now called Variable Interest Entities (VIEs), had to be evaluated for consolidation under ASC 810. The new guidance shifted to a qualitative analysis focused on which entity has the power to direct the VIE’s most significant activities.

This change forced many companies to bring billions of dollars of assets and liabilities back onto their balance sheets. The new model was designed to ensure that if a company controls an entity and is exposed to its risks and rewards, that entity should be included in its financial statements. This marked an evolution from FAS 140 toward greater transparency in financial reporting.