Accounting Changes for Loan Participations
Abbreviations Key
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FASB: Financial Accounting Standards Board
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ASC: Accounting Standards Codification
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SBA: Small Business Administration
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LIFO/FIFO: last in, first out/first in, first out
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On January 1, 2010, banks were required to adopt a standard for recording loans and securing financial assets. The standard was adopted from FASB Statement No. 140, (amended by statement 166 and subsequently codified by 860-20), and applies to transfers occurring on or after this date.
“It is important for banks to understand how this change may affect the sale treatment of loan participations sold, says Neil Falken, a financial institutions principal with LarsonAllen. If a loan does not qualify for sale treatment it may impact the institution’s legal lending limits. Banks should consult with their regulatory agencies as it relates to legal lending limits concerns.”
Loan transfers prior to January 1, 2010, are not affected by this new accounting standard.
Transfers that are “participating interests” qualify
In order to qualify for sale accounting, it is the responsibility of the lead institution to evaluate whether the transfer meets the four conditions of the new standard. A transfer is a “participating interest” (as defined in ASC 860-20-40-6A) when these conditions are met:
- The transfer is structured so that there are proportionate ownership rights with equal priority to each participating interest holder (pro rata ownership for all parties involved).
- There is no recourse (other than standard representations and warranties) to, or subordination by, any participant.
- All cash flows from the loan are divided proportionately among the participants, excluding reasonable servicing fees. The servicing fees exclusion only applies if the fees are not subordinate to the proportionate cash flows and are not significantly higher than the amount necessary to fairly compensate the lead institution. Each participant (including the lead institution) must have the same priority and no participant can have recourse to the lead institution.
- The entire financial asset can’t be pledged or exchanged unless all participants have agreed to do so.
The transfer of the participating interest must also meet the conditions for surrender of control.
If a participation sold does not meet the definition of a participating interest and the conditions for a transfer of control, both the lead bank transferring the participation and the financial institution purchasing the participation must account for the transaction as a secured borrowing with a pledge of collateral.
Examples of when a “participation sold” does not qualify
An example of when a participation sold would not meet the definition of participating interest is when a “last in, first out” provision exists, allowing one participant to receive loan payments prior to another participant. This does not qualify because it allows a participating interest holder to receive disproportionate cash flows from the loan payments.
Another example is a participation agreement with a pass-through interest rate to the participant that is substantially less than the contract rate. Usually this difference exists to compensate the lead institution for servicing the loan.
Impact on government-backed loans
The FASB 166 guidance also impacts the accounting for government-guaranteed portions of loans, such as those guaranteed by the SBA. If an institution transfers the 75 percent guaranteed portion of an SBA loan at a premium, the lead institution is obligated by the SBA to refund the premium to the SBA if the loan is paid within 90 days of the transfer. Under the new standard, this premium refund obligation is a form of recourse, which means that the guaranteed, sold portion of the loan doesn’t meet the definition of a participating interest for the 90-day period that the premium refund obligation exists. The transfer must be accounted for as a secured borrowing during the 90-day period. After this period, the guaranteed portion can be accounted for as a sale if all the conditions of sale accounting are met.
How to handle renewals, restructures, and modifications
If an event occurs to a loan following the adoption of the new guidance (i.e. a modification, restructure, or renewal) which requires reconsideration of a prior transfer accounted as a sale under previous guidance, the company must determine whether the event constituted a “substantive change” to the transaction.
The company will need to consider whether the loan is a “new loan” or a continuation of the old loan using the guidance in ASC 310-20-35-9 through 11. If it is a new loan, it must be evaluated under ASC 860-20. If not a new loan, or thus considered a continuation of the old loan, the transfer would not need to be re-considered under the new guidance. The transferor must also evaluate whether there have been any changes to the participation agreement which may also trigger further analysis.
“Community banks sell the vast majority of their loan participations on a pro-rata basis. It’s that small portion of loans that are sold on a LIFO/FIFO basis or other accounting method, that needs to be addressed,” Falken says.
How we can help
For more information on loan participations and how it may impact your institution, contact Neil Falken at nfalken@larsonallen.com or 612-376-4532, or a financial institutions principal in your region.
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