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Revenue Recognition Impact on Banks


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Banks obtain fees (such as commitment fees or trust fees) from multitudinous transactions. Interest revenues are generated principally from loans; however, interest also is realized through Eurodollar deposits, repurchase agreements (repos), investment securities (bonds), etc. The AICPA has an excellent Audit and Accounting Guide, Banks and Savings Institutions. The guide applies to federal (national) and state banks, and also to savings and loans (thrifts) and foreign bank branches in the United States. I

nterest income is recognized from its source under GAAP accrual basis guidelines. However, FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Lease, which applies to commercial bank lending, requires commitment and loan origination fees to be included with interest revenue.

Pursuant to Statement 91, the loan origination fees, commitment fees, and direct loan costs held for investment should be deferred and recognized as an adjustment to interest income over the life of the loan using the interest method; that is, an adjustment of yield for any fees (such as appraiser fees) received from borrowers under Statement 91 for the origination loan services performed by third parties should be recognized as revenue when the services have been performed.

Because of the many fees and their various consequences to a commercial bank, the FASB and the AICPA have issued the following documents for guidance (available from the FASB website www.fasb.org and the AICPA website www.aicpa.org):

EITF Issue No. 97-3, Accounting for Fees and Costs Associated with Loan Syndications and Loan Participations after the Issuance of FASB Statement 125;

FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a replacement of FASB Statement No. 125;

AICPA Practice Bulletin No. 5, Income Recognition on Loans to Financially Troubled Countries; and

AICPA Practice Bulletin No. 6, Amortization of Discounts on Certain Acquired Loans.

FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which impacts commercial banking transfers for servicing financial assets and the treatment of certain liabilities, was recently amended by FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140, and FASB Statement No. 156, Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140.

Statement 155 merely eliminates the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. The statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006.

Of greater importance to revenue recognition is Statement 156, which is also effective after September 15, 2006 (with earlier adoption permitted). It sets forth the following specific points:

An entity must recognize a servicing asset or servicing liability, in certain situations, every time it undertakes an obligation to service a financial asset by entering into a servicing contract.
All separately recognized servicing assets and servicing liabilities must be initially measured at fair value, if practicable.

The new standard of fair value at initial acquisition involves measurement based on discounted or future cash flows.

For each class of separately recognized servicing assets and servicing liabilities, an entity may select either the amortization method or the fair value measurement method:

Under the amortization method, servicing assets or servicing liabilities are amortized in proportion to and over the period of estimated net servicing income or net servicing loss. At each reporting date, servicing assets or servicing liabilities are assessed, based on fair value, for impairment or increased obligation.

Under the fair value measurement method, servicing assets or servicing liabilities are measured at fair value at each reporting date. Changes in fair value are reported in earnings in any period in which changes occur.

Entities with recognized servicing rights may make a one-time reclassification of available-for-sale securities to trading securities, at the time they initially adopt Statement 156.

Servicing assets and servicing liabilities that are subsequently measured at fair value must be presented separately in the statement of financial position, and additional disclosures are required for all separately recognized servicing assets and servicing liabilities.

The changes brought about by Statement 156 mean potential significant profit enhancement for commercial banks and much needed boosting of revenues. This is especially true with a continued rise in interest rates, and is a significant change for banks.

EXAMPLE

Bank had a portfolio of $100 million that it purchased in servicing assets. At the end of its fiscal year, this portfolio dropped in value, because of a decline in interest rates, to $95 million. Prior to the FASB’s amendment of Statement 140, Bank would reflect the portfolio at the lower of cost or market value, or $95 million, thereby reducing its net income by $5 million.
If interest rates had begun to rise (as per the present money market conditions, according to the Federal Reserve Bank), then, under pre-amendment conditions, the servicing asset portfolio could only be marked up to its original acquisition cost of $100 million, regardless of the increased market value. In this case, if the portfolio rose to $110 million from its prior quarter value of $95 million, Bank could only reflect a gain of $5 million (not $15 million), under the lower of cost or market value rule.
The amendment to Statement 140 allows Bank to recognize the full $15 million increase in value under the mark-to-market or full value rule. Also, the bank’s increase in earnings of $15 million is available to offset losses from associated derivatives or hedging instruments under the revised Statement 140 treatment.

Most commercial banks with mortgage lending affiliates or operations participate in hedging transactions. Think of mortgage servicing as a “derived demand” for the bank’s services. If interest rates rise, mortgages decline and so will their concomitant servicing (a possible scenario in coming years). To hedge or cover for this eventuality, banks purchase derivatives or hedging contracts. Originally, Statement 140 required that such hedging transactions be reflected at fair value, but mortgage servicing assets at the lower of cost or market value. The amendment simply makes the treatment of these two assets — derivatives associated with mortgage servicing and mortgage servicing assets — consistent.

Phantom Revenues
Some commercial banks have created a mortgage for homeowners and investors that has raised concerns in the banking industry and the investment community. It is the option adjustable rate mortgage or “ARM.” In an option ARM, the mortgagor has four monthly payment options; for example:

minimum payment, which doesn’t cover interest changes (resulting in the principal growing each period and creating negative amortization);
interest only, with no interest added to the principal balance;
regular (interest plus principal) payments on a fully amortizable 30-year loan; and
regular (interest plus principal) payments on a fully amortizable 15-year loan.

Because the option ARM is attractive to cash-strapped home buyers and investment-return buyers, most mortgagors chose the minimum payment option. Under that option, the interest rate (which is growing each month) adjusts the loan balance. At some point, the loan principal is reset and a new amortizable balance is set over the 30-year term, resulting in a revised mandatory repayment amount that can readily be three or four times the original monthly payment.Of concern to bank regulators and those investing in commercial bank stocks is the treatment of such loans by the mortgagees. Under existing GAAP, the mortgagee may book revenue on the option ARM at the fully amortized amount, despite the fact that the mortgagor is only paying the minimum amount (the negative amortization case). This booking of “phantom” future revenues is the disturbing result of option ARMs.

EXAMPLE

Mr. and Mrs. Smith enter into a $500,000 mortgage on a $550,000 Florida condominium. It is an option ARM and permits the Smiths, as mortgagors, to pay a minimum monthly amount of approximately $1,600. This does not result in the payment of any principal or the full amount of monthly interest on the 30-year term loan.
The fully amortizable monthly payment for the mortgagors is closer to $4,600, or about an additional $3,000 per month. The Florida bank books the interest portion of the $3,000 that it doesn’t receive as deferred interest revenue (many would say “phantom” revenue). At some point in the negative amortization process, the loan balance resets and the mortgagors must pay the new monthly amount of $4,600. However, in the Smiths’ case, the loan is “upside-down”; that is, the value of the investment condominium (because of a rapidly changing real estate market) is less than $500,000, so foreclosure is their only option.

If the commercial bank has a significant portion of its loan portfolio in such option ARMs, with a rising money market interest rate and declining real estate values, it is a prescription for trading losses. Such affected banks will follow GAAP and book the phantom revenues, increase earnings, and then move the non-performing option ARM mortgages to the held-for-sale marketable classification and, eventually, to collection agencies.

Excerpted by permission. Copyright 2007, Specialty Technical Publishers.