- An entire financial asset
- A group of entire financial assets
- A participating interest in an entire financial asset, in which circumstance the transferor shall recognize a servicing asset or a servicing liability only related to the participating interest sold.
Excerpt from ASC 860-50-25-2
A servicer that transfers or securitizes financial assets in a transaction that does not meet the requirements for sale accounting and is accounted for as a secured borrowing with the underlying financial assets remaining on the transferor’s balance sheet shall not recognize a servicing asset or a servicing liability.
Excerpt from ASC 860-50-25-3
A servicer that recognizes a servicing asset or servicing liability shall account for the contract to service financial assets separately from those financial assets.
Excerpt from ASC 860-50-25-4
An entity that transfers its financial assets to an unconsolidated entity in a transfer that qualifies as a sale in which the transferor obtains the resulting securities and classifies them as debt securities held to maturity in accordance with Topic 320 may either separately recognize its servicing assets or servicing liabilities or report those servicing assets or servicing liabilities together with the asset being serviced.
A servicing asset or servicing liability should be recognized when a company undertakes an obligation to service financial assets (i.e., the acquisition or assumption of the right to service a financial asset from a third party). Servicing rights related to failed sales (i.e., secured borrowings) or transfers to SPEs that are consolidated under ASC 810, would not qualify for separate recognition under ASC 860.
In accordance with ASC 860-50-55-4, if an entity transfers a participating interest in a financial asset that qualifies for sale accounting, the entity should record a servicing asset for the portion of the loan it sold. The assumption that the entity would service the loan because it retains part of the participated loan does not affect the requirement to recognize a servicing asset.
Recognition of servicing assets or servicing liabilities for revolving-period receivables shall be limited to the servicing for the receivables that exist and have been transferred. As new receivables are transferred into the revolving-period structure, rights to service those receivables should be recognized, to the extent the transfers to the structure meet the conditions for sale accounting.
Question TS 6-1 further clarifies the scope of transactions that are subject to ASC 860.Question TS 6-1
Would ASC 860 apply if a broker were to bring a bank and a borrower together in a brokered loan transaction and simultaneously enter into a servicing contract with the bank upon origination of the loan?
Yes. ASC 860 applies to any separate purchase or assumption of a servicing contract, regardless of whether a transfer of financial assets is connected to it, as outlined in ASC 860-50-30-1.
6.3.2 Initial measurement of servicing assets and liabilities
ASC 860-50-30 discusses some of the critical considerations when determining the initial measurement of a servicing asset or a servicing liability that qualifies for separate recognition. The guidance establishes that servicing contracts for which the servicer’s benefits of servicing are expected to more than adequately compensate the servicer will result in a servicing asset and contracts for which the benefits of servicing are not expected to adequately compensate the servicer will result in a servicing liability. The determination of adequate compensation considers the margin that would be demanded in the marketplace based on expected costs to serve; it does not vary based on the servicer’s own specific servicing costs. Servicing contracts that entitle the servicer to benefits equal to adequate compensation do not result in the recognition of a servicing asset or liability.
ASC 860 requires that separately recognized servicing rights be measured initially at fair value. ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Measurements of the fair value of servicing rights may consider the present value of expected cash flows, including both future inflows of servicing revenues and outflows of costs related to servicing. See TS 6.3.5 for a discussion of fair value measurements of servicing rights.
6.3.2.1 Determining whether a servicer is adequately compensated
A servicer of financial assets receives revenues from contractually specified servicing fees and other ancillary sources of income, including float and late charges. This income represents the benefits of servicing. In most cases, servicing contracts are structured such that the benefits of servicing are expected to more than adequately compensate the servicer for performing the servicing. The ASC Master Glossary defines benefits of servicing and adequate compensation. The determination of the adequacy of compensation is done on a contract by contract basis with no aggregation of contracts.
Definitions from ASC Master Glossary
Benefits of Servicing: Revenues from contractually specified servicing fees, late charges, and other ancillary sources, including float.
Adequate Compensation: The amount of benefits of servicing that would fairly compensate a substitute servicer should one be required, which includes the profit that would be demanded in the marketplace. It is the amount demanded by the marketplace to perform the specific type of servicing. Adequate compensation is determined by the marketplace; it does not vary according to the specific servicing costs of the servicer.
Adequate compensation is a market concept and should be made independent of the servicer’s internal cost structure. A servicer’s level of compensation should be compared to the level of compensation demanded by current market prices (i.e., the cost to service that servicers of similar assets would assume when buying the servicing in the marketplace, plus the profit margin they would demand).
Because the determination of a servicing asset or liability is based on the compensation demanded by the marketplace to perform the servicing, a company’s actual costs to service are irrelevant in determining whether a servicing asset or liability should be recorded. An efficient servicer could end up recording a liability, even if it can profitably perform the servicing below the contractually specified fee or "adequate compensation." Likewise, an inefficient servicer may be able to establish an asset, even though its actual cost to service may be higher.
The types of assets being serviced will impact the amount required to adequately compensate the servicer. ASC 860-50-30-7 provides an example that addresses these differences by distinguishing between the amount of effort that would be required to service a home equity loan from a credit card receivable or a small business administration loan. Some entities look to proxies, such as subservicing contracts, to help determine what adequate compensation, including a reasonable profit margin, would be for different assets being serviced.
The actual servicing costs and fees are recorded in the income statement as they are incurred or earned. Changes in the fair value of the servicing asset/liability are recorded in the income statement as they occur or through amortization. As a result, the income statement reflects the servicing contracts’ actual yield, including any efficiencies/inefficiencies in the entity’s own operations.
If a servicer is not adequately compensated by marketplace standards, a servicing liability should be recorded at fair value, even though the contractually specified fee may cover the servicing costs of that particular servicer. A contractual provision establishing the amount to be paid to a replacement servicer should not be utilized as the sole basis for determining fair value of servicing in the marketplace. However, that contractual provision would be a relevant provision for evaluating the overall fair value of the servicing contract.
If a servicer’s internal servicing costs exceed its compensation, a servicing liability should not be recorded as long as (1) the compensation represents what a substitute servicer would demand in the market, and/or (2) the servicer has the ability to sell its servicing rights to a substitute servicer, or to subcontract the servicing without incurring a loss. In these cases, the servicer’s internal servicing costs in excess of its servicing revenues should be recognized as a period cost during the term of the servicing contract. If, however, a servicer is contractually precluded from transferring its servicing rights or unable to subcontract the servicing without incurring a loss, a liability (at the time the servicing contract is entered into or assumed) equal to the unfavorable commitment for the contract’s remaining term should be recorded using a market-based cost assumption.
Question TS 6-2 discusses which standard should be applied when measuring revenue from a servicing contract.
Question TS 6-2
Does the recognition and measurement of revenue attributable to a servicing contract (relating to financial assets, such as residential mortgage loans) fall within the scope of ASC 606 or ASC 860?
ASC 860-50 addresses when a servicer of financial assets should record a servicing asset (or obligation) and directs how a servicer should account for the asset (or liability) in subsequent periods. However, other than requiring a servicer to disclose certain information about fees earned during the reporting period that relate to servicing assets or liabilities, the guidance is silent regarding the accounting for those fees by the servicer. Similarly, the guidance does not explicitly address subservicing fees; ASC 860-50 refers only to servicing contracts and related assets/liabilities.
There is diversity in practice concerning the applicable GAAP guidance for servicing and subservicing contracts deemed to have just adequate compensation. Servicing and subservicing contracts with more or less than adequate compensation fall within the scope of ASC 860 and are thus exempted from ASC 606, Revenue for Contracts with Customers. Although there is diversity in practice concerning servicing contracts with adequate compensation, revenue recognition patterns are likely similar under both standards and both standards require similar disclosures concerning amounts and significant assumptions. Entities with servicing contracts that contain incentive features and other unique revenue patterns should carefully consider the appropriate revenue recognition model.
6.3.3 Subsequent measurement of recognized servicing rights
ASC 860-50-35 provides guidance on the measurement attribute for servicing assets and servicing liabilities subsequent to initial recognition.
Excerpt from ASC 860-50-35-1
- Amortization method. Amortize servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income (if servicing revenues exceed servicing costs) or net servicing loss (if servicing costs exceed servicing revenues), and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date.
- Fair value measurement method. Measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value of servicing assets and servicing liabilities in earnings in the period in which the changes occur.
Excerpt from ASC 860-50-35-1A
A servicing asset may become a servicing liability, or vice versa, if circumstances change.
The guidance allows entities to account for servicing assets and servicing liabilities subsequent to initial measurement and recognition at either amortized cost subject to an impairment test or fair value. See TS 6.3.5 and TS 6.3.6 for additional information.
6.3.4 Classes of servicing assets and servicing liabilities
Different elections for subsequent measurement can be made for different classes of servicing assets or servicing liabilities. Entities must elect and apply one of the methods for each "class" of servicing assets and servicing liabilities.
ASC 860-50-35-5 requires that classes of servicing assets and servicing liabilities be identified based on one or both of the following: (a) the availability of market inputs used to determine the fair value of servicing assets or servicing liabilities and/or (b) an entity’s method for managing the risks of its servicing assets or servicing liabilities. The number of classes will affect a company’s disclosures because a number of the disclosures are required by class of servicing assets and servicing liabilities. See FSP 22.7 for information on the disclosure of servicing assets and servicing liabilities.
There is not a uniform approach mandated by GAAP for identifying classes of servicing assets or servicing liabilities. An entity may consider grouping them by the nature of the assumptions underlying the fair value of the servicing assets or servicing liabilities (e.g., prepayment and default rates). The fair value of servicing assets or servicing liabilities is generally determined using valuation models that incorporate a number of different assumptions because quoted market prices for servicing rights are generally not available.
In other cases, a company may find it more appropriate to base the grouping on its risk management strategies. The risks of servicing assets and servicing liabilities will often differ among asset types, and companies may manage those risks separately. A company may use derivative financial instruments or available-for-sale (AFS) securities to economically hedge the risks or may not hedge the risks at all. As a result, a company’s method for defining classes may differ depending on the complexity of its risk management strategies. Factors such as the nature of the collateral, fixed or floating interest rates, commercial or consumer loans, credit quality, and tenor (which all impact customer prepayment rates) may influence how an entity manages its risk exposure and, ultimately, how it defines its classes.
If the right to service a new class of financial assets is contractually undertaken, the election of a subsequent measurement method for the new class should be documented on the date on which the company acquires that right.
6.3.5 Fair value measurement method
The fair value election is irrevocable and can be made at the beginning of any fiscal year. For example, if a calendar year-end company elects to subsequently account for Class A servicing assets at fair value on January 1, 20X1, the company cannot change to the amortization method in any subsequent period. However, this does not prevent the company from electing to subsequently value its Class B servicing assets at amortized cost. If the fair value election is made, changes in the fair value of servicing rights should be recognized in earnings at each reporting date.
When the fair value measurement method is elected, it is beneficial for that election to be supported by concurrent documentation or a pre-existing documented policy for automatic election. As the fair value method can be elected at the beginning of any fiscal year, "concurrent" would mean that a company documents its election at the beginning of the fiscal year in which it applies the fair value method to that specific class of servicing assets or servicing liabilities.
The fair value measurement method requires an entity to measure classes of servicing assets or servicing liabilities at fair value at each reporting date, with changes in fair value recorded in earnings in the period during which they occur. ASC 860 does not define how fair value must be measured. An entity should look to ASC 820 for guidance on how to measure the fair value of servicing assets and liabilities.
Under ASC 820, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The basis for a fair value measurement is the market price at which a company would sell or otherwise dispose of assets or transfer liabilities (i.e., an exit price), not the market price that an entity pays to acquire assets or assume liabilities (i.e., not an entry price). ASC 820 further requires that the price used be based on the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. Refer to FV 4 for additional information.
ASC 820 requires that an entity maximize the use of observable inputs and minimize the use of unobservable inputs. Observable inputs that reflect quoted prices in active markets for identical assets or liabilities are the best evidence of fair value. Markets that provide quoted prices may include exchange, dealer, and principal-to-principal markets. Quotation and pricing services may also provide observable price quotations. However, there is no exchange market that provides both price quotations and an active market in servicing rights.
Care should be exercised when evaluating quoted prices to ensure that the prices used are representative of the servicing rights being valued. Prices can vary significantly based on the underlying characteristics of the loans. Quoted prices for newly-originated individual servicing rights on agency-conforming mortgage loans may be more readily available than quoted prices for other types of mortgage loans, which may require the use of alternative valuation methods.
The fair value of the servicing assets or liabilities should represent the difference between the benefits of servicing and adequate compensation. The initial measure for servicing may be zero if the benefits of servicing are just adequate to compensate the servicer for its responsibilities.
If quoted prices are not available, the estimate of fair value should be based on the best information available, given the circumstances. Often, in these cases, the prices of similar assets and liabilities represent the best information. If neither quoted market prices for the servicing assets or liabilities nor quoted market prices for similar servicing assets or liabilities are available, fair value should be estimated using other valuation techniques. These may include a present value of estimated future cash flows, option-pricing models, matrix pricing, option-adjusted spread models, or fundamental analysis. Regardless of the valuation technique used, the fair value of servicing assets or liabilities should represent the present value of a stream of cash flows, composed primarily of the servicing fees collected by the servicer, net of cash outflows that would be used by a market participant for performing the administrative tasks of servicing (e.g., collecting cash from borrowers, paying real estate taxes and hazard insurance, and remitting cash to third parties) and a market profit margin. It should also include all fees contractually due to the servicer (e.g., late payment fees). In determining the exact stream of cash flows that will be collected by the servicer (and, therefore, the fair value of the servicing rights), the amount and timing of cash flows are forecasted based on a number of assumptions.
The assumptions used in the model should be reasonable and supportable. All available evidence should be considered when estimating expected future cash flows. When servicing rights are valued using discounted cash flow analyses, the assumptions used in the valuation (primarily prepayment speeds, discount rate, delinquency and default rates, escrow earnings rates and the cost to service) should be consistent with the assumptions that would be used by a market participant independently evaluating the same portfolio of servicing for purchase.
In many situations, assumptions that market participants would use in computing the fair value of servicing rights are not available due to a limited number of market participants, imperfect information, or other conditions. In such cases, companies will likely need to estimate expected cash flows related to servicing activities using their own historical cash flow experience as a basis for formulating assumptions. ASC 820 allows this approach only to the extent that an entity can demonstrate that its own assumptions provide a reasonable proxy for market participant assumptions. It is also important to evaluate the nature of the cash flows that are included in the computation to ensure that they are consistent with the types of cash flows that a market participant would use to determine fair value.
For mortgage servicing rights, information regarding assumptions used can be obtained from independent servicing brokers in the market and from other sources, such as peer and industry group surveys. In addition, many mortgage servicers engage external third-party appraisers to provide estimates of fair value of their mortgage servicing rights.
Estimated future net servicing income includes estimated future cash inflows and outflows related to servicing. Estimates of cash inflows or servicing revenues should include servicing fees and other ancillary revenue, including float and late charges. Estimates of cash outflows or servicing costs should include direct costs associated with performing the servicing function and appropriate allocations of other costs. Estimated future servicing costs should be determined on a market value basis.
Critical assumptions used to determine estimated fair value generally include servicing fee to be earned, prepayment and default rates, discount rate, cost of servicing, float income, ancillary fees, default estimates, interest income on escrow and principal and interest balances, inflation factors, and interest paid on escrows.
