Investments in Debt and Equity Securities
7.01 Financial institutions acquire securities for various purposes. In addition to providing a source of income through investment or resale, securities are used to manage interest-rate and liquidity risk as part of an institution's overall asset/liability management strategies. They are also used in certain collateralized transactions. The most common securities acquired by institutions are described in the subsequent paragraphs. Investments that meet the definition of a security as defined in the FASB Accounting Standards Codification (ASC) glossary are discussed in this chapter. Other investments, including nonmarketable equity securities such as investments in Federal Home Loan Bank (FHLB) stock and Federal Reserve Bank stock, are discussed in chapter 12, “Other Assets, Other Liabilities, and Other Investments,” of this guide.
7.02 A direct relationship generally exists between risk and return (the higher the security’s risk, the higher its expected yield). An inverse relationship generally exists between the security’s liquidity and its yield; less liquid and longer-term securities generally have higher yields. Achieving the proper mix of safety, liquidity, and yield in an investment portfolio is one of the primary tasks of management. In managing their investment portfolios, financial institutions seek to maximize their returns without jeopardizing the liquidity the portfolios provide. Asset/liability management is discussed further in chapter 5, “Audit Considerations and Certain Financial Reporting Matters,” of this guide.
7.03 Management policies, adopted by the board of directors or its investment committee, establish authority and responsibility for investments in securities. Such policies may address investment objectives and guidelines, including specific position limits for each major type of investment, provisions for assessing risks of alternative investments, and policies on evaluating and selecting securities dealers and safekeeping agents. They also may set forth procedures for ensuring that management's investment directives are carried out and for gathering, analyzing, and communicating timely information about investment transactions.
7.04 The institution generally should have procedures to analyze alternative securities (including complex derivative securities which are defined as securities whose value is derived from that of some underlying asset(s)) according to the institution's intent, with consideration of the level of management expertise, the sophistication of the institution's control procedures and monitoring systems, its asset/liability structure, and its capacity to maintain liquidity and absorb losses out of capital. For example, analyses prepared for derivative securities prior to purchase would generally include sensitivity analyses that show the effect on the carrying amount and net interest income of various interest-rate, credit loss, and prepayment scenarios. Such analyses may also evaluate the effect of investment securities on the institution's overall exposure to interest-rate risk. An analysis might also be performed to evaluate the reasonableness of interest-rate, credit loss, and prepayment assumptions provided by the selling broker, and management may obtain price quotes from more than one broker prior to executing a trade. Management may also review contractual documents to ascertain the rights and obligations of all parties to the transaction, as well as the recourse available to each party.
U.S. Government and Agency Obligations
7.05 The Department of the Treasury (U.S. Treasury), as fiscal agent for the United States, routinely sells federal government debt securities called treasuries or T-bills. Backed by the full faith and credit of the United States, treasuries are generally considered the reference for the risk-free rate and are highly liquid. The income they provide is generally exempt from state and local taxes. Accordingly, treasuries are used by institutions as a primary source of liquidity.
7.06 T-bills are considered short term obligations, having original maturities of one year or less. T-bills are sold at a discount from their face value; income to T-bill investors is the difference between the purchase price and the face value. U.S. Treasury notes and bonds (T-notes and T-bonds, respectively) are longer-term obligations that pay interest in semiannual coupon payments. T-notes have original maturities between 1 and 10 years; T-bonds have maturities of 10 years or longer.
7.07 The debt of U.S. government agencies, such as the Government National Mortgage Association (Ginnie Mae), and government-sponsored enterprises (GSEs), such as the Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae), trades at yields above treasury yields but historically below that of high credit quality corporate debt. The agencies and GSEs issue debentures, notes, and other debt securities having a wide variety of maturities and other features. The GSEs, as public shareholder owned companies, were placed into conservatorship on September 6, 2008, at the direction of the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System (Federal Reserve) and the Director of Federal Housing Finance Agency. This changed the perception of both GSEs from being implicitly government backed to explicitly government backed along with Ginnie Mae.
7.08 State and local governments and their agencies (such as housing, school, or sewer authorities) issue notes and bonds of various maturities. Many municipal bonds are callable: they may be redeemed by the municipality before the scheduled maturity date. Tax anticipation notes, so named under the expectation that they will shortly be repaid with tax receipts, generally mature within one year and are usually purchased directly from the state or local government at a negotiated price. Revenue and bond anticipation notes are similarly issued and retired with certain expected revenues or proceeds from the expected sale of bonds. Municipal bonds may be either general obligation (that is, backed by the full taxing authority of the issuer) or limited obligation (that is, used to finance specific long term public projects, such as building a school). Municipal bonds are purchased through a competitive bidding process or in the secondary market.
7.09 Municipal obligations vary significantly in risk. Credit quality depends heavily on the ability and willingness of the municipality to service its debt or the profitability of the particular project being financed. Liquidity also varies. A number of municipal obligations are traded actively on over-the-counter markets; others are thinly traded. Interest on most municipal obligations is exempt from taxes in the state of the municipality; exemption from federal income taxes depends on the extent to which the obligations benefit private parties rather than the public. (See chapter 16, “Income Taxes,” of this guide for additional discussion of tax-exempt income.)
7.10 According to the FASB ASC glossary, a conduit debt security is defined as certain limited-obligation revenue bonds, certificates of participation, or similar debt instruments issued by a state or local governmental entity for the express purpose of providing financing for a specific third party (the conduit bond obligor) that is not part of the state or local government’s financial reporting entity. Although conduit debt securities bear the name of the governmental entity that issues them, the governmental entity often has no obligation for such debt beyond the resources provided by a lease or loan agreement with the third party on whose behalf the securities are issued. Further, the conduit bond obligor is responsible for any future financial reporting requirements.
7.11 The definition of public entity, as stated in the FASB ASC glossary, includes a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
7.12 Asset-backed securities (ABSs) are financial instruments that derive their value and receive cash flows from other financial assets (such as mortgage loans or credit card receivables). ABSs historically provided a great level of liquidity to financial markets, allowed for a wide variety of innovative products, and, because they often involve incrementally more risk, offered better yields than other investments.
7.13 ABSs are highly versatile because cash flows from the underlying assets can be reconfigured through any number of structures for repayment to ABS investors. ABSs allow the issuer to enhance the marketability of the underlying assets, for example, by spreading liquidity and credit risk across broad pools, or by providing a higher yield to those investors willing to accept a higher concentration of the risks associated with specific cash flows from the collateral.
7.14 This chapter focuses on ABSs from the perspective of the security holder. Chapter 10, “Transfers and Servicing and Variable Interest Entities,” and chapter 15, “Debt,” of this guide discuss matters unique to depository institutions that issue ABSs.
7.15 A given ABS structure generally involves any number of investment classes (or tranches) with various degrees of risk and reward. Among other common characteristics, ABSs
• are issued by both governmental and private issuers, including banks and savings institutions;
• generally include a credit allocation structure (for example, payout order of priority) or some form of credit enhancement to limit the credit risk of the underlying assets. For example, an issuer or third party may guarantee that the ABS principal and interest will be repaid as scheduled regardless of whether cash is received from payments on the underlying collateral; and
• are often issued in book-entry form. That is, no physical certificates change hands; rather, ownership is recorded on the investor's account.
7.16 The largest volumes of ABSs issued are backed by real estate mortgage loans (mortgages) and are called mortgage-backed securities (MBSs). Other types of collateral that have been used in ABS issuances include credit card receivables, treasuries (in synthetic structures), car loans, recreational vehicle loans, mobile home loans and trust preferred securities (TPSs) issued by financial institutions and insurance companies. MBSs and other mortgage securities are discussed in the following paragraphs to provide examples of risk characteristics and other matters that may be encountered with various forms of ABSs and their collateral.
7.17 MBSs. The simplest form of the ABS is the basic (or plain vanilla) MBS, created by pooling a group of similar mortgages. The collateral of a MBS may be residential real estate or commercial real estate. Most MBSs are issued with a stated minimum principal amount and interest rate and represent a pro rata share in the principal and interest cash flows to be received as the underlying mortgages are repaid by the mortgagors. The mortgages underlying the issuance typically have
a. the same type of collateral, such as single-family residential real estate;
b. fixed or adjustable interest rates within a specified range; and
c. maturities within a specified range.
7.18 MBSs are securities issued by a GSE or government agency (for example, Ginnie Mae, Freddie Mac, or Fannie Mae) or by private issuers (for example, banks, and mortgage banking entities). MBSs may be mortgage participation certificates or pass-through certificates, which represent an undivided interest in a pool of specific mortgage loans. Periodic payments on Ginnie Mae, Freddie Mac, and Fannie Mae participation certificates are backed by those agencies.
7.19 Risk characteristics of MBSs. Because the repayment of MBSs is contingent on repayment of the underlying loans, the risk characteristics of specific MBS issuances are driven by the risk characteristics of the underlying loans. For example, underlying mortgages insured by the Federal Housing Administration (FHA) would typically involve less credit risk than unguaranteed conventional mortgages.
7.20 More complex MBS structures. More complex MBS structures concentrate or dilute risk to create a range of possible investments with unique risks and rewards. As described in the following paragraphs, an understanding of the structure and nature of a specific MBS is necessary to understand the related risks. This understanding is important, for example, when evaluating whether an investment in a particular tranche of an MBS is other-than-temporarily impaired under FASB ASC 320, Investments—Debt and Equity Securities. Such an understanding is also important in making an assessment of whether an embedded derivative exists that would require bifurcation under FASB ASC 815, Derivatives and Hedging.
7.21 Credit risk. To make a particular issuance of MBS more attractive to potential investors, the credit risk associated with mortgages underlying MBSs is generally reduced through some form of credit enhancement, such as
a. a letter of credit;
b. guarantee of scheduled principal or interest payments, often achieved through a transaction with a federal agency such as Ginnie Mae, or a GSE such as Freddie Mac or Fannie Mae;
c. guarantee of all or a portion of scheduled principal and interest payments through insurance of the pool by a private mortgage insurer;
d. overcollateralization of the issuance, where cash flows from the excess collateral are used to make up for delinquent collateral payments; and
e. a senior/subordinated (senior/sub) structure, in which one group of investors holds a subordinated interest in the pool by accepting all or a large portion of the related credit risk in return for a greater yield.
7.22 The degree of protection from credit risk offered by the various types of credit enhancement generally needs to be considered in relation to the characteristics of the collateral and, therefore, is unique to each security. Further, when credit risk is addressed through a credit enhancement, the security holder is still at risk that the third-party guarantor or private insurer could default on its responsibility. (The risk that another party to a transaction will default on its obligations under the transaction is referred to as counterparty risk.) Many MBS issuances carry credit ratings assigned by an independent rating agency.
7.23 Interest rate risk and prepayment risk. The overall return — or yield — earned on a mortgage depends on the amount of interest earned over the life of the loan and any discount received or premium paid at acquisition. Mortgage yields, therefore, are highly sensitive to the fact that most mortgages can be repaid before their scheduled maturity date without penalty. Although the owner of a mortgage receives the full amount of principal when prepaid, the interest income that would have been earned during the remaining period to maturity — net of any discount or premium amortization — is lost.
7.24 As with individual mortgages, the actual maturities and yields of MBSs depend on when the underlying mortgage principal and interest are repaid. If market interest rates fall below a mortgage's contractual interest rate, it is generally to the borrower's advantage to prepay the existing loan and obtain new financing at a new, lower rate. Accordingly, expected prepayments must be estimated to predict and account for the yield on MBSs.
7.25 In addition to changes in interest rates, actual mortgage prepayments depend on other factors such as loan types and maturities, the geographical location of the related properties (and associated regional economies), seasonality, age and mobility of borrowers, and whether the loans are assumable, as are certain loans insured by the FHA or guaranteed by the U.S. Department of Veterans' Affairs. Prepayments are also dependent on availability of liquidity in the market; during the recession that begin in 2007, interest rates decreased as a result of market factors and the Federal Reserve’s monetary policy, but prepayments did not increase as expected because financial institutions were approving less refinances than they would in a normalized market environment.
7.26 Some MBSs are backed by adjustable-rate mortgages (ARMs). Interest rates on ARMs change periodically based on an independent factor plus an interest-rate spread, which is expressed as a specified percentage (1 percent, also referred to as one point) or one one-hundredth of a percentage (.01 percent, also referred to as one basis point). For example, an ARM might carry a rate that changes every 6 months based on the average rate on 1 year treasuries plus 2 points. Annual increases in an ARM's interest rate are generally capped, as are total interest-rate increases over the life of the loan.
7.27 Yields on ARMs follow changes in stipulated interest rate indexes. This, and the fact that some ARMs may been issued with teaser rates that are significantly below market rates as a way to attract borrowers, make it more difficult to predict the overall risk of investments in ARM MBSs. The frequency of interest-rate adjustments, the index, the initial interest rate, and the annual and lifetime caps all generally should be considered. For example, credit risk may be higher for ARM MBSs because when interest rates rise borrowers' ability to pay is diminished as their monthly payments increase.
7.28 Changes in the indexed rates of certain ARMs lag behind changes in prevailing rates. When interest rates are falling, adjustable-rate MBSs generally trade at a premium, although frequently they are prepaid as borrowers seek to lock in lower fixed rates. Conversely, when interest rates are rising, adjustable-rate MBSs generally trade at a discount.
7.29 Other MBSs. Other MBSs add layers of complexity to the security structure to create investment classes that meet the needs of and are attractive to more potential investors. Security holders find certain investment classes attractive because they can purchase the cash flows they desire most, or can synthetically create a security with the desired interest rate and prepayment characteristics. As discussed previously, MBSs offer pro rata shares in principal and interest cash flows with stated principal amounts and interest rates, and are subject to credit, prepayment, and other risks. More complex MBSs are used to further restructure the cash flows and risks so that investment classes may offer features which include the following:
• Different anticipated maturities
• A single final payment (called a zero-coupon class) rather than monthly, quarterly, or semiannual installments
• Floating interest rates, even though the underlying assets have fixed rates
• Repayment on a specified schedule, unless mortgage prepayments go outside a prescribed range (called a planned amortization class)
• Protection against faster but not slower prepayments (called a targeted amortization class)
• Rights to interest cash flows only, called interest-only securities (IOs), or to principal cash flows only, called principal-only securities (POs)
• Rights only to those cash flows remaining after all other classes have been repaid (a residual interest or residual)
• Lower risk of default and resulting higher investment ratings
• Higher yield (generally achieved through subordination)
7.30 These and other specialized classes — and the fact that some MBSs use pools of MBSs rather than pools of mortgages as collateral — make analysis of investments in MBSs complex. Accordingly, such instruments could expose an institution to substantial risk if not understood or effectively managed by the institution.
7.31 Two common forms of multiclass MBSs are collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs). CMOs are bonds secured by (and repaid with) the cash flows from collateral MBSs or mortgages and generally involve some form of credit enhancement. The collateral is generally transferred to a special-purpose entity (SPE) which may be organized as a trust, a corporation, or a partnership. The SPE is an entity created by an asset transferor or sponsor to carry out a specific purpose, activity or series of transactions directly related to its specific purpose. The SPE then becomes the issuer of the CMO (see consolidation considerations for SPEs and former qualifying special purpose entities in paragraph 7.118 and beginning in paragraph 10.93 of this guide. Accordingly, a security holder may invest in a CMO in equity form (for example, trust interests, stock, and partnership interests) or nonequity form (for example, participating debt securities). REMICs are a form of CMO specially designated for federal income tax purposes so that the related income is taxed only once (to the security holder). See chapter 16 of this guide.
7.32 Understanding the risks associated with a particular tranche of a MBS or other ABS often requires an understanding of the security structure, as documented in the offering document and related literature. The term tranche refers to one of several related securities offered that are collateralized by the same group of assets. Tranches from the same offering usually have different risks, rewards, or maturity characteristics.
7.33 Risk analysis. A discussion of the risks associated with every possible form of MBS or other ABS is beyond the scope of this Audit and Accounting Guide. A basic understanding of the relationship between interest and principal cash flows, in addition to an understanding of related risks (such as credit risk), is needed to analyze investments in MBSs. The following discussion uses IOs, POs, and residuals as examples of ABS classes for this purpose. The discussion of the senior/sub structure used in some issuances also highlights the importance of understanding the structure and the form of credit enhancement when evaluating an investment in mortgage products or other ABSs.
7.34 Investment classes that have a contractual right only to certain interest cash flows (interest classes), such as MBS IOs, are extremely interest-rate and prepayment sensitive and, therefore, carry the risk that the security holder's entire recorded investment could be lost. Investment classes weighted toward solely principal cash flows (principal classes), such as MBS POs, also carry special risks. The following discussion of related risk concepts can be applied to various other investments in MBSs or other ABSs.
7.35 Interest classes and IOs. Interest classes receive all, or substantially all, of the interest cash flows from the underlying collateral mortgages. Accordingly, they have been found to be useful vehicles for managing the interest-rate risk inherent in mortgage portfolios, because prepayments cause the value of IOs to move in the opposite direction from that of mortgages and traditional fixed-income securities. However, because of the sensitivity of IOs to interest rates, the recorded investment in an IO may be lost if actual prepayments are higher than anticipated.
7.36 Changes in the prices (and, therefore, the values) of MBSs are heavily dependent on whether the collateral’s interest rates are above or below prevailing interest rates. A mortgage will trade at a discount (a discount mortgage) when it carries an interest rate lower than prevailing interest rates. A mortgage that carries an interest rate above prevailing rates will trade at a premium (a premium mortgage).
7.37 An IO backed by a pool of premium mortgages may be a more useful tool for controlling interest-rate risk than one backed by a pool of discount mortgages because it often shows greater appreciation in value when interest rates increase and often does not suffer as significant a decrease in value when interest rates fall. Falling interest rates generally result in greater prepayments. Accordingly, the cash generated from an IO over its life usually decreases because interest is earned on a smaller remaining principal balance. Although the discounting of the stream of interest receipts at a lower interest rate increases the present value of each future dollar of interest, the negative effect of increased prepayments generally outweighs the positive discounting effect, and, therefore, the fair value of the IO generally declines. IOs generally increase in value in a rising rate environment because as prepayments slow, the related mortgage principal balance remains outstanding for a longer period, and, therefore, interest is earned for a longer period (although the present value of each of those future dollars is reduced by the higher discount rate).
7.38 Principal classes and POs. Principal classes are often issued at deep discounts from the contractual principal amount because the security holder receives no interest. In contrast to zero-coupon bonds, whose entire principal amount is paid at maturity, the principal amount of POs is paid periodically according to repayment of the underlying mortgage principal. If the security holder has the ability to hold the PO to maturity, only credit risk or counterparty default would prevent ultimate recovery of the recorded investment. The fair value of a PO is also dependent on the effects of prepayments and discounting, both of which are dependent on interest rates.
7.39 The fair value of a PO often tends to increase as prepayments accelerate, because the security holder receives the return of principal more quickly. Conversely, as prepayments slow, the value of the PO often tends to decline. A PO backed by discount mortgages tends to appreciate more as interest rates fall than would a PO backed by premium mortgages. However, when interest rates rise, a PO backed by discount mortgages would not decline in value as much as a PO backed by premium mortgages. The difference in fair values reflects the relationship between prepayment rates and the stated interest rates on the collateral backing the POs. Prepayments on discount POs are generally significantly lower than prepayments on premium POs. As interest rates decline, prepayments on both types of POs will accelerate. However, prepayments on premium POs do not increase as much, because prepayments on these instruments are usually already at a high level. Conversely, when interest rates rise, prepayments on underlying discount mortgages do not slow significantly, because they are usually already at a relatively low level, but prepayments on underlying premium mortgages decline sharply.
7.40 A decline or increase in interest rates similarly causes the fair value of expected cash flows from POs to increase or decrease, respectively, because of related changes in the discount rate used to determine the present value of any future cash flows.
7.41 Because POs generally increase in value in response to declining interest rates, they are sometimes used to manage the interest-rate risk associated with investments in mortgage servicing rights, CMO or REMIC residuals, and IOs. However, institutions in liability-sensitive positions (that is, institutions whose liabilities will reprice more quickly than their assets) would be negatively affected by an increase in interest rates, and, therefore, the use of POs to manage the interest-rate risk of such assets may be counterproductive because such a strategy may increase the institution's overall exposure to interest-rate risk.
7.42 Residual classes. From a legal perspective, residuals represent an ownership interest in the underlying collateral, subject to the first lien and indenture of the other security holders. Residuals entitle the holder to the excess, if any, of the issuer's cash inflows (including reinvestment earnings) over cash outflows (which often include any debt service and administrative expenses). Three sources of residual cash flows typically exist:
a. The differential between interest cash flows on the collateral and interest payments on other investment classes
b. Any overcollateralization provided as a credit enhancement
c. Any income earned on reinvestment of other cash flows before they are distributed to other security holders (because payments on collateral mortgages are received monthly but some investment classes are repaid quarterly or semiannually, these receipts are reinvested in the interim)
7.43 Residuals are often designed to reduce the prepayment and credit risk of other classes and to provide security holders with the potential for high yields. Residuals may earn high yields if prepayments and credit losses of the underlying collateral are not greater than the rate assumed at the time the issuance was structured and sold. Residuals are particularly sensitive to prepayments, and the residual holder's recorded investment may be lost entirely if actual prepayments are higher than anticipated. They also represent the riskiest tranche of securities, as they are first in line to absorb credit losses, which is why they have the potential for high yields. As with POs and IOs, their fair values are dependent on the effect of discounting.
7.44 Typically residuals absorb credit losses. However, they could also absorb other risks such as interest rate risk and related prepayment risk. Although other investment classes may receive triple-A credit ratings, residuals are usually not rated, because they are so susceptible to interest-rate risk. Even if a residual is rated triple-A, such a rating often indicates only that the rating agency expects that the minimum required payments of principal, interest, or both will be received (that is, that credit risk is perceived to be low), not that a security holder will realize the anticipated yield.
7.45 As with other investment classes, the return on and fair value of a residual is dependent on the underlying collateral, the security structure, and its performance under varying interest-rate and prepayment scenarios. Residuals may carry fixed- or floating-interest rates.
7.46 The fair value of fixed-rate residuals often increases as interest rates increase and decreases as interest rates decline. The main source of cash flow on a fixed-rate residual comes from the interest differential between the interest payments received on the underlying collateral mortgages and the interest payments made on other investment classes. Because short term classes usually carry lower interest rates than longer-term classes, residual cash flows from the interest differential tend to be greatest in earlier years after issuance, before the short term classes have been repaid. Accordingly, the longer the lower-rate classes remain outstanding, the greater the cash flow accruing to the residual class. As interest rates decline, prepayments accelerate, the interest differential narrows, and overall cash flows decline. Conversely, as interest rates climb, prepayments slow, generating a larger cash flow to residual holders.
7.47 As with fixed-rate residuals, the main source of cash flow to floating-rate residuals is the interest differential between interest earned on the collateral and interest paid on other investment classes. However, because one or more of the classes is tied to a floating rate, the interest differential can change when the rates on floating-rate classes are reset. For example, when interest rates rise, the rate on the floating-rate class may be reset at a higher rate. More of the cash flows from the underlying collateral may then be paid to the floating-rate classes, leaving less cash flow for the residual. Higher interest rates also tend to cause prepayments to slow, and thereby increase the period over which the interest-differential income is earned by the residual holders. Conversely, when interest rates decline, rates on floating-rate classes decrease, but prepayments of premium mortgages would tend to accelerate. The loss of interest income as a result of prepayments would typically offset a widening of the interest differential stemming from the lower rate on the floating-rate class, thus reducing the cash flow to the residual. Thus, changes in interest rates produce two opposing effects on the fair value of floating-rate residuals. Whether the value of the residual actually declines or rises when interest rates change depends on the interrelationship between factors such as the interest on the floating-rate class and mortgage prepayment speeds.
7.48 Senior/sub securities. The senior/sub form of credit enhancement is often used for conventional mortgages. A senior/sub issuance generally divides the offered securities into two risk classes, namely, a senior class and one or more subordinated classes. The subordinated classes, often retained by the sponsor of the ABS, provide credit protection to the senior class. When cash flows on the underlying mortgages are impaired, the cash is first directed to make principal and interest payments on the senior-class securities. Furthermore, some cash receipts may be held in a reserve fund to meet any future shortfalls of principal and interest to the senior class. The subordinated classes may not receive debt-service payments until all of the principal and interest payments have been made on the senior class and, where applicable, until a specified level of funds has been contributed to the reserve fund.
7.49 Subordinated classes generally carry higher interest rates and are often unrated because of the higher credit risk. Accordingly, subordinated classes are not usually purchased to be held to maturity. The fair value of subordinated securities, like the fair value of other MBSs, depends on the nature of the underlying collateral and how changes in interest rates affect cash flows on the collateral. The fair value would also reflect any reserve fund priorities and the increased credit risk associated with the securities.
Other Structured Credit Products
7.50 The following discussion addresses certain common characteristics of other structured credit products such as structured notes, TPSs, and pooled TPSs. These general characteristics along with those unique to the various securities are important considerations when evaluating the related risks.
7.51 On April 30, 2009, the FDIC issued Financial Institution Letter (FIL)-20-2009, “Risk Management of Investments in Structured Credit Products.” According to the FDIC FIL, the term structured credit products may be broadly defined to refer to all structured investment products where repayment is derived from the performance of the underlying assets or other reference assets, or by third parties that serve to enhance or support the structure. Such products include MBSs and CMOs, as previously discussed. These products also include, but are not limited to, structured investment vehicles, collateralized debt obligations (CDOs), including securities backed by TPSs, and other ABSs. As previously noted, a discussion of the risks associated with all forms of structured credit product is beyond the scope of this guide.
7.52 Structured notes. Structured notes are hybrid securities that combine fixed term, fixed or variable rate instruments, and derivative products. Structured notes are debt securities issued by corporations or GSEs, including FHLB, Fannie Mae, and Freddie Mac. Structured notes generally contain embedded options and have cash flows that are linked to the indexes of various financial variables, such as interest rates, foreign exchange rates, commodity prices, prepayment rates, and other financial variables. Structured notes can be linked to different market sectors or interest rate scenarios, such as the shape of the yield curve, the relationship between two different yield curves, or foreign exchange rates.
7.53 TPSs. Investments in TPSs are also hybrid instruments possessing characteristics typically associated with debt obligations. Although each issue of these securities may involve minor differences in terms, under the basic structure of TPSs a corporate issuer, such as a bank holding company, first organizes a business trust or other special purpose entity. This trust issues two classes of securities: common securities, all of which are purchased and held by the corporate issuer, and TPSs, which are sold to investors. The corporate issuer makes periodic interest payments on the subordinated debentures to the business trust, which uses these payments to pay periodic dividends on the TPSs to the investors. The subordinated debentures have a stated maturity and may also be redeemed under other circumstances. Most TPSs are subject to a mandatory redemption upon the repayment of the debentures. Because of the mandatory redemption provision in the typical TPS, investments in TPSs would normally be considered debt securities under FASB ASC 320.
7.54 TPSs have a payment deferral feature of up to 5 years and, in general, have a 30 year maturity. In the event of bankruptcy, TPSs are below all senior and subordinated debt, but above equity securities in priority. In addition, TPSs generally are rated by nationally recognized rating firms.
7.55 Pooled TPSs. In a pooled TPSs offering, an additional trust is added to the structure and is referred to as a business trust. A pooled TPS is a form of CDO backed by various TPSs. The business trust issues securities to investors and uses the proceeds to purchase all of the TPSs from the grantor trust. The TPSs are then securitized, as the business trust is the sole investor of the securities.
7.56 Trust preferred pools issue several classes, or tranches, of securities, which include senior, mezzanine, and residual (also referred to as income) tranches. The senior tranches have priority of payment, with the subordinated residual interest and mezzanine positions absorbing losses earlier and serving as credit protection for the senior tranches. The TPSs include credit support provisions such that if performance in the underlying collateral deteriorates below certain levels, cash flows are diverted from the residual tranches to pay the senior and mezzanine tranches. Further deterioration may result in diversion of cash flows from the holders of the mezzanine tranches to pay the holders of the senior tranches. Securitization documents explain the priority of payments and the credit support levels of the various tranches.
7.57 Understanding the list of issuers that compose the portfolio, the current investment ratings, the status of the collateral (for example, the extent of any deferrals or defaults), and the credit quality of the institutions remaining in the pool are important aspects of these investments when considering the related risks.
7.58 The risks associated with pooled TPSs are heavily dependent upon the position in the securitization structure. It is important to understand the structure of the security, the priority of payments, and current credit support levels (for example, whether income is being diverted from the subordinate tranches to support the credit protection level of the senior tranches).
7.59 The underlying collateral for a significant number of structured credit products, including those previously addressed, has performed poorly during difficult credit environments. Due to the complex nature of these investments, the structural characteristics and the underlying collateral at the pool and individual investment level are important factors to be considered when evaluating the related risks and determining an appropriate valuation.
Issues of International Organizations and Foreign Governments
7.60 International financial institutions and foreign governments and their political subdivisions increasingly rely on international capital markets for funds. A significant portion of international debt securities is denominated in U.S. dollars. The credit risk and liquidity risk vary for different issues, though many are high quality and widely traded. Institutions have also obtained foreign debt securities of financially troubled countries in troubled debt restructurings; such securities are generally lower quality and not widely traded.
7.61 Other securities held by depository institutions, where permitted by applicable laws and regulations, include the following:
• Common-trust or mutual-investment funds
• Investments in negotiable certificates of deposit1
• Equity securities, including venture capital investments
• Corporate bonds and commercial paper
The credit quality and risk of these instruments are unique to the particular issuance. The financial strength of the issuer and other counterparties is a major determinant and may be evidenced by an investment rating.
Transfers of Securities
7.62 Short sales. Short sales are trading activities in which an institution transfers securities it does not own, with the intention of buying or borrowing securities at an agreed-upon future date to cover the transfer. Securities are “sold short” for protection against losses, for short term borrowing of funds, for arbitrage, or in anticipation of a decline in market prices.
7.63 Borrowing and lending securities. Sometimes an institution will borrow securities from a counterparty or from its trust customers’ assets when the institution is obligated to deliver securities it does not own. Examples are in a short sale, to settle a repurchase agreement, or because a counterparty may have failed to deliver securities the institution needed for delivery to another counterparty. The institution, therefore, uses borrowed securities to fulfill its obligation until it actually receives the securities it has purchased. Institutions also may loan securities to a counterparty.
7.64 An institution may advance cash, pledge other securities, or issue letters of credit as collateral for borrowed securities. The amount of cash or other collateral deemed necessary may increase or decrease depending on changes in the value of the securities.
7.65 Repurchase and reverse repurchase agreements. Sometimes an institution will enter into an agreement with a counterparty to sell (or purchase) securities and then buy (or sell) them back at a specified date. If the repurchase agreement is for the same or substantially similar securities, the transaction is not recorded as a sale (or purchase). Instead, the securities continue to be recorded as assets of the transferor and the transaction is recorded as a secured borrowing. Repurchase and reverse repurchase agreements are discussed further in chapter 14, “Federal Funds and Repurchase Agreements,” of this guide.
7.66 Federal laws and regulations place certain restrictions on the types of financial instruments that an institution may deal in, underwrite, purchase, and sell. Transactions in certain securities, such as those backed by the full faith and credit of the United States, are generally unrestricted. Holdings of other securities — of any one obligor — are generally limited based on capitalization. Restrictions on dealing in or underwriting in the security may also apply. Additional restrictions may apply to state-chartered institutions.
7.67 Banks and savings institutions. The Federal Financial Institutions Examination Council (FFIEC) issued the Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities dated April 23, 1998, that was adopted by all of the federal banking agencies. The policy statement provides guidance to financial institutions on sound practices for managing the risks of investment securities and end-user derivatives activities. The guidance describes the practices that a prudent manager normally would follow, but it emphasizes that it is not intended to be a checklist and management should establish practices and maintain documentation appropriate to the institution’s individual circumstances.
7.68 The FFIEC supervisory policy statement applies to all securities in held-to-maturity and available-for-sale accounts as described in FASB ASC 320, certificates of deposit held for investment purposes, and end-user derivative contracts not held in trading accounts. This guidance covers all securities used for investment purposes, including money market instruments, fixed-rate and floating-rate notes and bonds, structured notes, mortgage pass-through and other ABSs and mortgage-derivative products. Similarly, the guidance covers all end-user derivative instruments used for nontrading purposes, such as swaps, futures, and options.
7.69 The FFIEC supervisory policy statement also describes sound principles and practices for managing and controlling the risks associated with investment activities. Institutions should fully understand and effectively manage the risks inherent in their investment activities. The policy statement emphasizes that failure to understand and adequately manage the risks in these areas constitutes an unsafe and unsound practice.
7.70 Board of director and senior management oversight is an integral part of an effective risk management program. The board of directors is responsible for approving major policies for conducting investment activities, including the establishment of risk limits. Senior management is responsible for the daily management of an institution’s investments. Institutions with significant investment activities ordinarily should ensure that back-office, settlement, and transaction reconciliation responsibilities are conducted or managed by qualified personnel who are independent of those initiating risk taking positions.
7.71 An effective risk management process for investment activities includes (a) policies, procedures, and limits; (b) the identification, measurement, and reporting of risk exposures; and (c) a system of internal control. The policy statement identifies sound practices for managing specific risks involved in investment activities. These risks include
• market risk,
• credit risk,
• liquidity risk,
• operational (transaction) risk, and
• legal risk.
In addition, institutions are reminded to follow any specific guidance or requirements from their primary supervisor related to these activities.
7.72 As previously noted, the FDIC issued FIL-20-2009, which clarifies the application of existing supervisory guidance to structured credit products, including the 1998 supervisory guidance discussed in paragraphs 7.67–.71. Topics addressed in FIL-20-2009 include investment suitability and due diligence, the use of external credit ratings, pricing and liquidity, and adverse classification of investment securities.
7.73 FIL-20-2009 addresses concerns about the nonagency structured credit market. However, some of the clarifications in this guidance also are relevant for agency securities. See paragraphs 7.51–.60 for further discussion of other structure credit products.
7.74 The FDIC’s Risk Management Manual of Examination Policies includes a subchapter titled “Securities and Derivatives” which references these interagency guidance documents.
7.75 On December 13, 1999, the federal banking agencies, including the Office of Thrift Supervision (OTS) (prior to its transfer of powers to the Office of the Comptroller of the Currency [OCC], the FDIC, and the Federal Reserve),2 jointly released the Interagency Guidelines on Asset Securitization that highlight the risks associated with asset securitization and emphasize the agencies’ concerns with certain retained interests generated from the securitization and sale of assets. The guidelines set forth the supervisory expectation that the value of retained interests in securitizations must be supported by objectively verifiable documentation of the assets’ fair market value, utilizing reasonable, conservative valuation assumptions. Retained interests that do not meet such standards or that fail to meet the supervisory standards outlined in the guidance will be disallowed as assets of the bank for regulatory capital purposes. The guidance stresses the need for bank management to implement policies and procedures that include limits on the amount of retained interests that may be carried as a percentage of capital. Institutions that lack effective risk management programs or engage in practices deemed to present other safety and soundness concerns may be subject to more frequent supervisory review, limitations on retained interest holdings, more stringent capital requirements, or other supervisory response.
7.76 Federal and state savings associations. Thrift Bulletin (TB) 73a, Investing in Complex Securities, states that TPSs that otherwise meet the requirements of corporate debt securities3 are permissible investments for federal savings associations. Savings associations are, however, prohibited from purchasing TPSs or any other type of security from the parent holding company or any other affiliate. TB 73a can be found on the “Office of Thrift Supervision Thrift Bulletin” page at www.occ.gov and should be referred to for additional limitations and requirements for holding these securities. National banks and state nonmember banks are permitted to invest in trust preferred stock within certain limitations. (See OCC Interpretive Letter No. 777, April 8, 1997; FDIC FIL-16-99, February 16, 1999.) The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) did not change the prohibitions.
7.77 The Dodd-Frank Act authorized the FDIC to issue a final rule to establish standards of creditworthiness to replace previously used investment grade standards for corporate debt security investments held or acquired by savings associations. In July 2012, the FDIC’s board of directors, through the issuance of FIL-34-2012, Investments in Corporate Debt Securities by Savings Associations, adopted the final rule Permissible Investments for Federal and State Savings Associations: Corporate Debt Securities. The final rule prohibits state and federal savings associations from acquiring or holding a corporate debt security when the security’s issuer does not have an adequate capacity to meet all financial commitments under the security for the projected life of the security. In addition, the FDIC also issued final guidance that sets forth due diligence standards for determining the credit quality of a corporate debt security. Readers are encouraged to review the full text of the final rule and guidance in FIL-34-2012 from www.fdic.gov.
7.78 The Volcker rule of the Dodd-Frank Act, among other things, prohibits banks and other financial institutions from acquiring or retaining any ownership interests in or sponsorship of covered funds as defined in the rule. A recent focus has been on whether collateralized loan obligations (CLOs) qualify as covered funds. Although not exempt from the requirements, the Federal Reserve has extended the compliance deadline for CLOs by two years. See paragraph 7.88 for accounting considerations resulting from the Volcker rule.
7.79 Credit unions. Federal regulations describe investments allowed for federal credit unions.4,5These regulations explicitly prohibit federal credit unions from (a) purchasing mortgage servicing rights as an investment, (b) investing in stripped MBSs or certain securities that represent interests in stripped MBSs, (c) purchasing residual interests in CMOs, REMICs, or small-business-related securities, and (d) engaging in adjusted trading or short sales.6
7.80 Federally insured state-chartered credit unions are required under terms of the insurance agreement to establish an investment valuation reserve (displayed as an appropriation of retained earnings) for nonconforming investments. Nonconforming investments are those investments permissible under state law for a state-chartered credit union, but which are impermissible for federally chartered credit unions.
7.81 In October 2010, the National Credit Union Administration issued amendments to its rule governing corporate credit unions. The major revisions involved corporate credit union capital, investments, asset-liability management, governance, and credit union service organization activities. In regards to investments, the final amendments now involve a rigorous investment screening process prior to purchase. Some of the significant changes within the process include (a) Nationally Recognized Statistical Rating Organization ratings screen, (b) additional prohibition of certain highly complex and leveraged securities (specifically, a CDO, net interest margin security, private label residential MBS, or security subordinated to any other securities in the issuance), (c) single obligor limits tightened from 50 percent of capital to 25 percent of capital, (d) portfolio weighted average life (WAL) not to exceed two years, and (e) portfolio WAL (assuming prepayment slowdown of 50 percent) not to exceed 2.5 years. In addition, some corporations may hold investments that are in violation of one or more of these new prohibitions, and these investments will be subject to the investment action plan provisions.7
Bank Accounting Advisory Series
7.82 The OCC’s Bank Accounting Advisory Series (BAAS) is updated periodically to express the Office of the Chief Accountant’s current views on accounting topics of interest to national banks and federal savings associations. Banks prepare their Consolidated Reports of Condition and Income using U.S. generally accepted accounting principles (GAAP) and regulatory requirements. Accordingly, responses contained in the series are based on GAAP and regulatory requirements. These advisories are not official rules or regulations of the OCC; but rather, represent either interpretation by the OCC’s Office of the Chief Accountant of GAAP, or OCC interpretations of regulatory capital requirements. Topic 1, “Investment Securities” of the BAAS includes interpretations on (a) investment in debt and equity securities and (b) other-than-temporary-impairment (OTTI). Readers are encouraged to view this publication under the “Publications—Bank Management” page at www.occ.gov.
7.83 FASB ASC 320 addresses accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities, according to FASB ASC 320-10-05-2.8 FASB ASC 320-10-25-1 requires that at acquisition, an entity should classify debt securities and equity securities into one of these three categories:
a. Held-to-maturity securities. Investments in debt securities should be classified as held-to-maturity only if the reporting entity has the positive intent and ability to hold those securities to maturity. According to FASB ASC 320-10-35-1, investments in debt securities classified as held-to-maturity should be measured subsequently at amortized cost in the statement of financial position.
b. Trading securities. If a security is acquired with the intent of selling it within hours or days, the security should be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading should not be precluded simply because the entity does not intend to sell it in the near term. According to FASB ASC 320-10-35-1, trading securities should be measured subsequently at fair value in the statement of financial position and unrealized holding gains and losses should be included in earnings.
c. Available-for-sale securities. Available-for-sale securities are investments in debt and equity securities that have readily determinable fair values not classified as held-to-maturity securities or trading securities. According to FASB 320-10-35-1, available-for-sale securities are measured subsequently at fair value in the statement of financial position, with unrealized holding gains and losses excluded from earnings and reported as other comprehensive income until realized except as indicated in the following sentence. All or a portion of the unrealized holding gain and loss of an available-for-sale security that is designated as being hedged in a fair value hedge should be recognized in earnings during the period of the hedge, pursuant to paragraphs 1–4 of FASB ASC 815-25-35.
7.86 FASB ASC 825, Financial Instruments, allows entities to choose, at specified election dates, to measure eligible items at fair value (the fair value option) with gains and losses recorded in earnings at each subsequent reporting date. Chapter 20, “Fair Value,” of this guide provides a summary of FASB ASC 825 but is not intended as a substitute for reading the guidance in FASB ASC 825. Investments in securities may contain embedded derivatives that, absent a fair value option election, could require bifurcation and separate accounting under FASB ASC 815.
7.87 Paragraphs 4–18 of FASB ASC 320-10-25 describe certain circumstances not consistent with held-to-maturity classification and circumstances that are consistent with held-to-maturity classification. FASB ASC 320-10-25-6 addresses changes in circumstances that may cause the entity to change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. Entities rarely transfer securities out of the held-to-maturity category because a single transfer may call into question management’s intent and ability to hold the entire portfolio to maturity. FASB ASC 320-10-25-18 provides specific scenarios where sale or transfer of a held-to-maturity security will not call into question an investor's stated intent to hold other debt securities to maturity in the future.13
7.88 Compliance with the provisions of the Volcker rule (see paragraph 7.78) may have current accounting consequences. For example, entities should evaluate whether a positive intent and ability to hold held-to-maturity debt securities to maturity still exists. In addition, if it is more likely than not that an entity will be required to sell a debt security with a fair value that is less than its amortized cost, the manner in which impairment is recognized could be impacted.
7.89 Paragraphs 10–16 of FASB ASC 320-10-35 address transfers of securities between categories. The transfer of a security between categories of investments should be accounted for at fair value. In addition, given the nature of a trading security, transfers into or from the trading category also should be rare. Paragraphs 75–77 of FASB ASC 860-10-55 give an example addressing whether a transferor has the option to classify debt securities as trading at the time of a transfer.
7.90 FASB ASC 948-310-40-1 states that, after the securitization of a mortgage loan held for sale that meets the conditions for a sale addressed in FASB ASC 860-10-40-5, any MBSs received by a transferor as proceeds should be classified in accordance with the provisions of FASB ASC 320. However, FASB ASC 948-310-35-3A states that a mortgage banking entity should classify as trading any retained MBSs that it commits to sell before or during the securitization process. An entity is prohibited from reclassifying loans as investment securities unless the transfer of those loans meets the conditions for sale accounting addressed in FASB ASC 860-10-40-5.
7.91 FASB ASC 740-20-45-11b states that the tax effects of gains and losses included in comprehensive income but excluded from net income (for example, changes in the unrealized holding gains and losses of securities classified as available-for-sale under FASB ASC 320), as defined in the FASB ASC glossary, occurring during the year should be charged or credited directly to other comprehensive income or to related components of shareholders' equity.
7.92 FASB ASC 320-10-25-5a states that a security should not be classified as held-to-maturity if that security can contractually be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment. The justification for using historical-cost-based measurement for debt securities classified as held-to-maturity is that no matter how market interest rates fluctuate, the holder will recover its recorded investment and thus realize no gains or losses when the issuer pays the amount promised at maturity. However, that justification does not extend to receivables purchased at a substantial premium over the amount at which they can be prepaid, and it does not apply to instruments whose payments derive from prepayable receivables but have no principal balance. Therefore, a callable debt security purchased at a significant premium might be precluded from held-to-maturity classification under FASB ASC 860-20-35-2 if it can be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment. In addition, a mortgage-backed interest-only certificate should not be classified as held-to-maturity. Paragraphs 3–6 of FASB ASC 860-20-35 provide further guidance. Note that a debt security that is purchased late enough in its life such that, even if it was prepaid, the holder would recover substantially all of its recorded investment, could be initially classified as held-to-maturity if the conditions of FASB ASC 320-10-25-5 and FASB ASC 320-10-25-1 are met. (A debt security that can contractually be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment may contain an embedded derivative. Therefore, such a security should be evaluated in accordance with FASB ASC 815-15 to determine whether it contains an embedded derivative that needs to be accounted for separately).
7.93 See chapter 20 of this guide for a summary of FASB ASC 820, Fair Value Measurement.
7.94 Paragraphs 17–35A of FASB ASC 320-10-35 provide guidance regarding the impairment of individual available-for-sale and held-to-maturity securities, including the scope of impairment guidance, the steps for identifying and accounting for impairment, and the recognition of an OTTI. See paragraphs 7.129–.136 and FASB ASC 320-10-50 for disclosure requirements related to OTTI.
7.95 For individual securities classified as either available-for-sale or held-to-maturity, an entity should determine whether a decline in fair value below the amortized cost basis is other than temporary as stated in FASB ASC 320-10-35-18. Providing a general allowance for unidentified impairment in a portfolio of securities is not appropriate. Paragraphs 20–29 of FASB ASC 320-10-35 provide guidance an entity should follow in assessing impairment of individual securities classified as either available-for-sale or held-to-maturity. If the fair value of an investment is less than its amortized cost basis at the balance sheet date of the reporting period for which impairment is assessed, the impairment is either temporary or other than temporary, as stated in FASB ASC 320-10-35-30.
7.96 Equity securities. FASB ASC 320-10-35-32A states that for equity securities, an entity should apply the guidance that is pertinent to the determination of whether an impairment is other than temporary, such as FASB ASC 323-10-35 and FASB ASC 325-40-35. If it is determined that the impairment is other than temporary, then an impairment loss should be recognized in earnings equal to the entire difference between the investment’s cost and its fair value at the balance sheet date of the reporting period for which the assessment is made as stated in FASB ASC 320-10-35-34. The measurement of the impairment should not include partial recoveries after the balance sheet date. The fair value of the investment would then become the new amortized cost basis and that cost basis should not be adjusted for subsequent recoveries in fair value.
7.97 Debt securities. For debt securities, readers may refer to paragraphs 33A–33I of FASB ASC 320-10-35 for guidance on evaluating whether an impairment is other than temporary. Paragraphs 34A–34E of FASB ASC 320-10-35 provide guidance on determining the amount of an OTTI recognized in earnings and other comprehensive income if the impairment is other than temporary. The following paragraphs highlight certain sections of this guidance.
7.98 If an entity intends to sell the impaired debt security (that is, it has decided to sell the security), an OTTI should be considered to have occurred. If an entity does not intend to sell the impaired debt security, the entity should consider available evidence to assess whether it more likely than not will be required to sell the security before the recovery of its amortized cost basis (for example, whether its regulatory obligations indicate that the security will be required to be sold before a forecasted recovery occurs). If the entity more likely than not will be required to sell the security before recovery of its amortized cost basis, an OTTI should be considered to have occurred.
7.99 In assessing whether the entire amortized cost basis of the security will be recovered, an entity should compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis of the security, the entire amortized cost basis of the security will not be recovered (that is, a credit loss exists), and an OTTI should be considered to have occurred.
7.100 In determining whether a credit loss exists, an entity should use its best estimate of the present value of cash flows expected to be collected from the debt security. One way of estimating that amount would be to consider the methodology described in FASB ASC 310-10-35 for measuring impairment on the basis of the present value of expected future cash flows. Briefly, the entity would discount the expected cash flows at the effective interest rate implicit in the security at the date of acquisition. All of the factors, listed in FASB ASC 320-10-35-33F should be considered when estimating whether a credit loss exists and the period over which the debt security is expected to recover. This list is not meant to be all inclusive.
7.101 In making its OTTI assessment, an entity should consider the factors in paragraphs 33G–33H in FASB ASC 320-10-35. An entity also should consider how other credit enhancements affect the expected performance of the security, including consideration of the current financial condition of the guarantor of a security (if the guarantee is not a separate contract as discussed in FASB ASC 320-10-35-23) or whether any subordinated interests are capable of absorbing estimated losses on the loans underlying the security. The remaining payment terms of the security could be significantly different from the payment terms in prior periods (such as some securities backed by nontraditional loans; see FASB ASC 825-10-55-1). Thus, an entity should consider whether a security backed by currently performing loans will continue to perform when required payments increase in the future (including balloon payments). An entity also should consider how the value of any collateral would affect the expected performance of the security. If the fair value of the collateral has declined, an entity should assess the effect of that decline on the ability of the entity to collect the balloon payment.
7.102 If an OTTI has occurred, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If an entity does not intend to sell the debt security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the OTTI should be separated into both of the following:
a. The amount representing the credit loss
b. The amount related to all other factors
The amount of the total OTTI related to the credit loss should be recognized in earnings. The amount of the total OTTI related to other factors should be recognized in other comprehensive income, net of applicable taxes.
7.103 Subsequent increases and decreases (if not an OTTI) in the fair value of available-for-sale securities should be included in other comprehensive income, according to FASB ASC 320-10-35-35.
7.104 The OTTI recognized in other comprehensive income for debt securities classified as held-to-maturity should be accreted over the remaining life of the debt security in a prospective manner on the basis of the amount and timing of future estimated cash flows, as stated in FASB ASC 320-10-35-35A. That accretion should increase the carrying value of the security and should continue until the security is sold, the security matures, or there is an additional OTTI that is recognized in earnings.
7.105 A decline in the value of a security that is other than temporary is also discussed in AU-C section 501, Audit Evidence—Specific Consideration for Selected Items,16 and the SEC Codification of Staff Accounting Bulletins topic 5(M), “Other Than Temporary Impairment of Certain Investments in Equity Securities.”
Unrealized Gains and Losses
7.107 FASB ASC 220-10-45-1 requires an entity to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. According to paragraphs 1A–1C of FASB ASC 220-10-45, an entity reporting comprehensive income in a single continuous financial statement should present its components in two sections: net income and other comprehensive income. If applicable, an entity should present in that financial statement a total amount for net income together with the components that make up net income, a total amount for other comprehensive income together with the components that make up other comprehensive income, and total comprehensive income. An entity reporting comprehensive income in two separate but consecutive statements should present components of and the total for net income in the statement of net income and components of and the total for other comprehensive income as well as total for comprehensive income in the statement of other comprehensive income, which should be presented immediately after the statement of net income. A reporting entity should begin the second statement with net income. An entity should present, either in a single continuous statement of comprehensive income or in a statement of net income and statement of other comprehensive income, all items that meet the definition of comprehensive income for the period in which those items are recognized. Components included in other comprehensive income should be classified based on their nature. For related guidance, see paragraphs 10A–10B of FASB ASC 220-10-45.
7.108 FASB ASC 220-10-45-15 requires that reclassification adjustments be made to avoid double counting of items in comprehensive income that are presented as part of net income for a period that also had been presented as part of other comprehensive income in that period or earlier periods. For example, gains on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains in the period in which they arose must be deducted through other comprehensive income of the period in which they are included in net income to avoid including them in comprehensive income twice (see FASB ASC 320-10-40-2). Example 3 (see paragraphs 18–27 of FASB ASC 220-10-55) illustrates the presentation of reclassification adjustments in accordance with this paragraph.
7.109 FASB ASC 220-10-45-17 requires an entity to provide information about the effects on net income of significant amounts reclassified out of each component of accumulated other comprehensive income if those amounts all are required under other FASB ASC topics to be reclassified to net income in their entirety in the same reporting period. An entity should provide this information together, in one location, either (a) on the face of the financial statement where net income is presented or (b) as a separate disclosure in the notes to the financial statements. FASB ASC 220-10-45-17A describes the information requirements for presentation on the face of the statement where net income is presented, and FASB ASC 220-10-45-17B describes the information requirements for disclosure in the notes to the financial statements. FASB ASC 220-10-45-18B states that nonpublic entities are not required to meet the requirements in paragraphs 17–17B of FASB ASC 220-10-45 for interim reporting periods but are required to meet them for annual reporting periods.
Premiums and Discounts
7.110 An institution will often pay less (or more) for a security than the security's face value. Accretion of the resulting discount (or amortization of the premium), together with the stated coupon on the security, represents the effective rate of interest on the security, thereby reflecting the security's market yield.
7.111 Dividend and interest income,18 including amortization of the premium and discount arising at acquisition, for all three categories of investments in securities should be included in earnings, according to FASB ASC 320-10-35-4.
7.112 For a debt security transferred into the held-to-maturity category from the available-for-sale category, the unrealized holding gain or loss at the date of the transfer should continue to be reported in a separate component of shareholders' equity, such as accumulated other comprehensive income, but should be amortized over the remaining life of the security as an adjustment of yield in a manner consistent with the amortization of any premium or discount, as stated in item (d) in FASB ASC 320-10-35-10. The amortization of an unrealized holding gain or loss reported in equity will offset or mitigate the effect on interest income of the amortization of the premium or discount) for that held-to-maturity security. For a debt security transferred into the held-to-maturity category, the use of fair value may create a premium or discount that, under amortized cost accounting, should be amortized thereafter as an adjustment of yield pursuant to FASB ASC 310-20.
7.113 The guidance in FASB ASC 310-20 explicitly includes the accounting for discounts, premiums, and commitments fees associated with the purchase of loans and other debt securities such as corporate bonds, treasury notes and bonds, groups of loans, and loan-backed securities, as stated in item (b) in FASB ASC 310-20-15-2. FASB ASC 310-20-35-18 specifies that net fees or costs that are required to be recognized as yield adjustments over the life of the related loan(s) should be recognized by the interest method except as set forth in paragraphs 21–24 of FASB ASC 310-20-35. The objective of the interest method is to arrive at periodic interest income (including recognition of fees and costs) at a constant effective yield on the net investment in the receivable (that is, the principal amount of the receivable adjusted by unamortized fees or costs and purchase discount or premium).
7.114 FASB ASC 942-320-35-1 states that the period of amortization or accretion for debt securities should generally extend from the purchase date to the maturity date, not an earlier call date. FASB ASC 310-20-35-26 explains that if the entity holds a large number of similar loans for which prepayments are probable and the timing and the amount of the prepayments can be reasonably estimated, the entity may consider estimates of future principal prepayments in the calculation of the constant effective yield necessary to apply the interest method.
7.115 Certain ABSs may meet those conditions, and institutions may therefore consider estimates of prepayments in determining the amortization period for calculation of the constant effective yield.
7.116 In accordance with FASB ASC 310-20-35-26, if the institution anticipates prepayments in applying the interest method and a difference arises between the anticipated prepayments and the actual prepayments received, the effective yield should be recalculated to reflect actual payments to date and anticipated future payments. The net investment in the loans should be adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the loans. The investment in the loans should be adjusted to the new balance with a corresponding charge or credit to interest income.
7.117 Guidance for recognizing interest income on debt securities is included within FASB ASC 310-20, 320-10, 325-40, and 310-30. The appropriate model to apply depends on a number of factors including, but not limited to, the nature of the investment, its creditworthiness, and whether the asset was originated or purchased in the secondary market.
7.118 A reporting entity that holds a direct or indirect (explicit or implicit) variable interest in a legal entity must determine whether the guidance in the “Variable Interest Entities” subsections of FASB ASC 810-10 applies to that legal entity before considering other consolidation guidance. However, if a reporting entity does not have a direct or indirect (explicit or implicit) variable interest in a legal entity, then the reporting entity is not the primary beneficiary of that legal entity and is not required to provide disclosures for that legal entity under FASB ASC 810-10 “Variable Interest Entities” subsections. Variable interest entities (VIEs) may appear in various forms, such as TPSs, synthetic leases, asset-backed commercial paper conduits, and CDOs. See detailed discussion of consolidation considerations related to VIEs beginning in paragraph 10.93 of this guide.
7.119 The following paragraphs list several specialized accounting issues involving investments in securities.
7.120 Cost basis of debt security received in restructuring. FASB ASC 310-40-40-8A states that the initial cost basis of a debt security of the original debtor received as part of a debt restructuring should be the security's fair value at the date of the restructuring. Any excess of the fair value of the security received over the net carrying amount of the loan should be recorded as a recovery on the loan. Any excess of the net carrying amount of the loan over the fair value of the security received should be recorded as a charge-off to the allowance for credit losses. Subsequent to the restructuring, the security received should be accounted for according to the provisions of FASB ASC 320.
7.121 Sales of marketable securities with put arrangements. Paragraphs 20–23 of FASB ASC 860-20-55 address transactions that involve the sale of a marketable security to a third-party buyer, with the buyer having an option to put the security back to the seller at a specified future date or dates for a fixed price. If the transfer is accounted for as a sale, a put option that enables the holder to require the writer of the option to reacquire for cash or other assets a marketable security or an equity instrument issued by a third party should be accounted for as a derivative by both the holder and the writer, provided the put option meets the definition of a derivative in FASB ASC 815-10-15-83 (including meeting the net settlement requirement, which may be met if the option can be net settled in cash or other assets or if the asset required to be delivered is readily convertible to cash).
Transfers and Servicing of Securities
7.122 FASB ASC 860-10 establishes accounting and reporting standards for transfers and servicing of financial assets, according to FASB ASC 860-10-05-1. FASB ASC 860-10-05-6 also provides an overview of the types of transfers addressed, including securitization, factoring, transfers of receivables with recourse, securities lending transactions, repurchase agreements, loan participation, and banker’s acceptances. Refer to chapter 10 of this guide for additional guidance regarding transfers and servicing of securities.
7.123 Trade date accounting. FASB ASC 942-325-25-2 states that regular-way purchases and sales of securities should be recorded on the trade date. Gains and losses from regular-way security sales or disposals should be recognized as of the trade date in the statement of operations for the period in which securities are sold or otherwise disposed of.21
7.124 Short sales. As stated in FASB ASC 942-405-25-1 and FASB ASC 942-405-35-1, the obligations incurred in short sales should be reported as liabilities. Such liabilities are generally called securities sold, not yet purchased. The obligations should be subsequently measured at fair value through the income statement at each reporting date. Interest on the short positions should be accrued periodically and reported as interest expense. The fair value adjustment should be classified in the income statement with gain and losses on securities, according to FASB ASC 942-405-45-1.
Troubled Debt Restructurings
7.125 In accordance with item (a) in FASB ASC 320-10-55-2, any loan that was restructured as a security in a troubled debt restructuring involving a modification of terms would be subject to the provisions of FASB ASC 320 if the debt instrument meets the definition of a security. See FASB ASC 310-40-40-8A for additional information.
7.126 FASB ASC 310-40 addresses measurement, derecognition, disclosure and implementation guidance issues concerning creditor’s treatment of troubled debt restructurings. According to FASB ASC 310-40-15-4, receivables that may be involved in troubled debt restructurings commonly result from lending cash, or selling goods or services on credit. Examples are accounts receivable, notes, debentures and bonds (whether those receivables are secured or unsecured and whether they are convertible or nonconvertible), and related accrued interest, if any. FASB ASC 310-40-35-5 states that a creditor in a troubled debt restructuring involving only a modification of terms of a receivable — that is, not involving receipt of assets (including an equity interest in the debtor) — should account for the troubled debt restructuring in accordance with the provisions of FASB ASC 310-40. This topic is discussed in more detail in chapter 8, “Loans,” of this guide.
7.127 Troubled debt restructuring may involve debt securities, including instances in which there is a substitution of debtors, which is addressed in FASB ASC 310-40-25-2.
Loans and Debt Securities Acquired With Deteriorated Credit Quality
7.128 FASB ASC 310-30 provides recognition, measurement, and disclosure guidance regarding loans acquired with evidence of deterioration of credit quality since origination acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable, according to FASB ASC 310-30-05-1. FASB ASC 310-30 is discussed in more detail in chapter 8 of this guide.
Financial Statement Presentation and Disclosure
7.129 OTTIs. Paragraphs 8A and 9A of FASB ASC 320-10-45 state that in periods in which an entity determines that a security’s decline in fair value below its amortized cost basis is other than temporary, the entity should present the total OTTI in the statement of earnings with an offset for the amount of the total OTTI that is recognized in other comprehensive income, in accordance with FASB ASC 320-10-35-34D, if any. FASB ASC 320-10-55-21A illustrates the application of this guidance. An entity should separately present, in the financial statement in which the components of accumulated other comprehensive income are reported, amounts recognized therein related to held-to-maturity and available-for-sale debt securities for which a portion of an OTTI has been recognized in earnings.
7.130 FASB ASC 320-10-50 addresses disclosures about OTTIs for debt and equity securities and requires a detailed, risk-oriented breakdown of major security types and related information. Disclosures related to this guidance are required for all interim and annual periods.
7.131 Paragraphs 2 and 5 of FASB ASC 320-10-50 require that the following information about available-for-sale and held-to-maturity securities be disclosed separately for each of those categories:
a. For securities classified as available-for-sale, all reporting entities should disclose all of the following by major security type as of each date for which a statement of financial position is presented:
i. Amortized cost basis
ii. Aggregate fair value
iii. Total OTTI recognized in accumulated other comprehensive income
iv. Total gains for securities with net gains in accumulated other comprehensive income
v. Total losses for securities with net losses in accumulated other comprehensive income
vi. Information about the contractual maturities of those securities as of the date of the most recent statement of financial position presented.
b. For securities classified as held-to-maturity, all reporting entities should disclose all of the following by major security type as of each date for which a statement of financial position is presented:
i. Amortized cost basis
ii. Aggregate fair value
iii. Gross unrecognized holding gains
iv. Gross unrecognized holding losses
v. Net carrying amount
vi. Total OTTI recognized in accumulated other comprehensive income
vii. Gross gains and losses in accumulated other comprehensive income for any derivatives that hedged the forecasted acquisition of the held-to-maturity securities
viii. Information about the contractual maturities of those securities as of the date of the most recent statement of financial position presented.
7.132 Maturity information may be combined in appropriate groupings, as stated in paragraphs 3 and 5 of FASB ASC 320-10-50. In complying with this requirement, financial institutions (see FASB ASC 942-320-50-1) should disclose the fair value and the net carrying amount (if different from fair value) of debt securities on the basis of at least the following four maturity groupings:
a. Within one year
b. After one year through five years
c. After five years through ten years
d. After ten years
Securities not due at a single maturity date, such as MBSs, may be disclosed separately rather than allocated over several maturity groupings; if allocated, the basis for allocation should be disclosed.
7.133 In accordance with FASB ASC 942-320-50-2, in complying with the disclosure requirements mentioned in paragraph 7.131, financial institutions should include all of the following major security types, though additional types also may be included as appropriate:
a. Equity securities, segregated by any one of the following:
i. Industry type
ii. Entity size
iii. Investment objective
b. Debt securities issued by the U.S. Treasury and other U.S. government corporations and agencies
c. Debt securities issued by states within the United States and political subdivisions of the states
d. Debt securities issued by foreign governments
e. Corporate debt securities
f. Residential MBSs
g. Commercial MBSs
i. Other debt obligations
7.134 Paragraphs 4–5 of FASB ASC 942-320-50 explain that the carrying amount of investment assets that serve as collateral to secure public funds, securities sold under repos, and other borrowings, that are not otherwise disclosed under FASB ASC 860, Transfers and Servicing, should be disclosed in the notes to the financial statements. The notes to the financial statements should include an explanation of the institution's accounting policy for securities, including the basis for classification. An entity should disclose the carrying amount of securities deposited by insurance subsidiaries with state regulatory authorities, as stated in FASB ASC 944-320-50-1.
7.135 For all investments in an unrealized loss position, including those within the scope of FASB ASC 325-40, for which OTTI has not been recognized in earnings (including investments for which a portion of an OTTI has been recognized in other comprehensive income), FASB ASC 320-10-50-6 states that an entity should disclose all of the following items in its interim and annual financial statements:
a. As of each date for which a statement of financial position is presented, quantitative information aggregated by category of investment — each major security type that the entity discloses in accordance with FASB ASC 320-10 and cost-method investments — in tabular form:
i. The aggregate related fair value of investments with unrealized losses
ii. The aggregate amount of unrealized losses (that is, the amount by which amortized cost basis exceeds fair value)
b. As of the date of the most recent statement of financial position, additional information (in narrative form) that provides sufficient information to allow financial statements users to understand the quantitative disclosures and the information that the entity considered (both positive and negative) in reaching the conclusion that the impairment or impairments are not other than temporary. (The application of step 2 in FASB ASC 320-10-35-30 should provide insight into the entity’s rationale for concluding that unrealized losses are not OTTIs. The disclosures required may be aggregated by investment categories, but individually significant unrealized losses generally should not be aggregated.) This disclosure could include all the following:
i. The nature of the investment(s)
ii. The cause(s) of the impairment(s)
iii. The number of investment positions that are in an unrealized loss position
iv. The severity and duration of the impairment(s)
v. Other evidence considered by the investor in reaching its conclusion that the investment is not other-than-temporarily impaired, including, for example, any of the following:
1. Performance indicators of the underlying assets in the security, including default rates, delinquency rates, or percentage of nonperforming assets
2. Loan-to-collateral-value ratios
3. Third-party guarantees
4. Current levels of subordination
6. Geographic concentration
7. Industry analyst reports
8. Sector credit ratings
9. Volatility of the security’s fair value
10. Any other information that the investor considers relevant
7.136 This guidance also requires disclosures regarding the significant inputs used in determining a credit loss, as well as rollforward of that amount each period. For interim and annual periods in which an OTTI of a debt security is recognized and only the amount related to a credit loss was recognized in earnings, an entity should disclose by major security type, the methodology and significant inputs used to measure the amount related to credit loss. FASB ASC 320-10-50-8A provides examples of significant inputs and FASB ASC 320-10-50-8B addresses the tabular rollforward of the amount related to credit losses recognized in earnings and provides certain items which should be disclosed within the rollforward.
7.137 Sales or transfers. For each period for which the results of operations are presented FASB ASC 320-10-50-9 requires that the institution disclose all of the following:
a. The proceeds from sales of available-for-sale securities and the gross realized gains and gross realized losses that have been included in earnings as a result of those sales
b. The basis on which cost of a security sold or the amount reclassified out of accumulated other comprehensive income into earnings was determined (that is, specific identification, average cost, or other method used)
c. The gross gains and gross losses included in earnings from transfers of securities from the avail-able-for-sale category into the trading category
d. The amount of the net unrealized holding gain or loss on available-for-sale securities for the period that has been included in accumulated other comprehensive income and the amount of gains and losses reclassified out of accumulated other comprehensive income into earnings for the period25
e. The portion of trading gains and losses for the period that relates to trading securities still held at reporting date
7.138 In accordance with FASB ASC 320-10-50-10, for any sales of or transfers from securities classified as held-to-maturity, an entity should disclose all of the following in the notes to the financial statements for each period for which the results of operations are presented: (a) the net carrying amount of the sold or transferred security, (b) the net gain or loss in accumulated other comprehensive income for any derivative that hedged the forecasted acquisition of the held-to-maturity security, (c) the related realized or unrealized gain or loss, and (d) the circumstances leading to the decision to sell or transfer the security. Such sales or transfers should be rare, except for sales and transfers due to the changes in circumstances identified in items (a)–(f) in FASB ASC 320-10-25-6. FASB ASC 320-10-25-14 sets forth the conditions under which sales of debt securities may be considered as maturities for purposes of the disclosure requirements under FASB ASC 320-10-50-10.
7.139 Concentration-of-credit-risk. The concentrations-of-credit-risk disclosures apply to debt securities as well as loans. FASB ASC 825-10-50-20 states that, except as indicated in FASB ASC 825-10-50-22, an entity should disclose all significant concentrations of credit risk arising from all financial instruments, whether from an individual counterparty or groups of counterparties.
7.140 Mutual funds. Investments in mutual funds that invest only in U.S. government debt securities may be shown separately rather than grouped with other equity securities in the disclosures by major security type required by FASB ASC 942-320-50-2, according to FASB ASC 320-10-50-4.
7.141 The primary objectives of audit procedures in this area are to obtain reasonable assurance that
a. securities, accrued interest, and discounts and premiums of the institution
i. exist at the balance sheet date (definitive securities are on hand or held by others in custody or safekeeping for the account of the institution) and are owned by the institution.
ii. have been properly classified, described, and disclosed in the financial statements at appropriate amounts (including consideration of any other-than-temporary declines in value and disclosure of any securities pledged as collateral for other transactions).
b. sales of securities and other transactions that occurred
i. have been recorded during the appropriate period.
ii. are properly classified, described, and disclosed.
c. realized and unrealized gains and losses, and interest (including premium amortization and discount accretion), dividend, and other revenue components
i. have been included in the financial statements at appropriate amounts.
ii. are properly classified, described, and disclosed.
7.142 In accordance with AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement, the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement (see chapter 5 of this guide for further information).
7.143 The primary inherent risks related to investments — interest-rate risk, credit risk, and liquidity risk — are interrelated. For example, increases in market interest rates may affect other risk factors by decreasing marketability (that is, liquidity) or by increasing the credit risk of the issuer's obligations. The auditor’s understanding of the relationship between the interest-rate environment and the market values of securities might include review of the institution's asset/liability and other risk management policies, which may provide useful information about the possible effects of interest rate and liquidity risks on the institution's securities.
7.144 Another risk inherent to complex investments is the business risk that the institution does not properly understand the terms and economic substance of a significant complex investment. Such misunderstandings could result in the incorrect pricing of a transaction and improper accounting for the investment or related income. (See chapter 18, “Derivative Instruments: Futures, Forwards, Options, Swaps, and Other Derivative Instruments,” of this guide.) Inquiry of a specialist could be considered by the auditor if a financial institution engaged in holding or trading such complex securities.
7.145 If the preparation of the financial statements involves the use of expertise in a field other than accounting, paragraph .A7 of AU-C section 620, Using the Work of an Auditor’s Specialist, states that the auditor, who is skilled in accounting and auditing, may not possess the necessary expertise to audit those financial statements. The engagement partner is required by AU-C section 220, Quality Control for an Engagement Conducted in Accordance With Generally Accepted Auditing Standards, to be satisfied that the engagement team and any external auditor’s specialists (defined in the auditing standards as an individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist the auditor in obtaining sufficient appropriate audit evidence) who are not part of the engagement team, collectively, have the appropriate competence and capabilities to perform the audit engagement.28 Further, the auditor is required by AU-C section 300, Planning an Audit, to ascertain the nature, timing, and extent of resources necessary to perform the engagement.29 The auditor’s determination of whether to use the work of an auditor’s specialist, and, if so, when and to what extent, assists the auditor in meeting these requirements. As the audit progresses or as circumstances change, the auditor may need to revise earlier decisions about using the work of an auditor’s specialist.
Considerations for Audits Performed in Accordance With PCAOB Standards30
PCAOB Staff Audit Practice Alert No. 11, Considerations for Audits of Internal Control Over Financial Reporting (PCAOB Staff Guidance, sec. 400.11),31 highlights certain requirements of the auditing standards of the PCAOB in aspects of audits of internal control over financial reporting in which significant auditing deficiencies have been cited frequently in PCAOB inspection reports. Specifically, the alert discusses, among other topics, using the work of others.
7.146 Classification of investments in securities among the held-to-maturity, available-for-sale, and trading categories is important because it directly affects the accounting treatment. The classification of securities, which must occur at acquisition, ordinarily should be consistent with the institution's investment, asset/liability, and other risk management policies. The independent auditor should ascertain whether the accounting policies adopted by the entity for investments are in conformity with GAAP. In planning the audit, the independent auditor may consider reading the current year's interim financial statements, investment policy, and other financial information related to securities. The level of inherent risk for securities varies widely from institution to institution depending on, among other things, the nature and complexity of the securities and the extent and effectiveness of the institution's accounting and operational policies and procedures, as well as management's understanding and awareness of the risks. The following factors related to securities may, considered in the aggregate, indicate higher inherent risk:
a. Significant concentrations of credit risk with one counterparty or within one geographic area
b. Significant use of complex securities, particularly without relevant in-house expertise
c. Excessively high volumes of borrowing or lending of securities
d. Relatively high volatility in interest rates
e. Changes in the terms of government guarantees
f. Actual prepayment experience that differs significantly from that anticipated
g. Declines in the values of collateral underlying securities
h. Changes in guarantors' claims processing
i. Significant conversion options related to the collateral (for example, variable to fixed rates)
j. Sales and transfers from the held-to-maturity securities portfolio
k. Uncertainty regarding the financial stability of an ABS servicer or of guarantors
l. Uncertainty regarding the financial stability of a safekeeping agent or other third party holding the institution’s securities
m. Changes in accounting systems, including software and manual processes
n. Differing assumptions used in determining fair values will result in different conclusions
o. Significant reliance on outside parties.
Internal Control Over Financial Reporting and Possible Tests of Controls
7.147 AU-C section 315 addresses the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through understanding the entity and its environment, including the entity’s internal control. Paragraphs .13–.14 of AU-C section 315 state that the auditor should obtain an understanding of internal control relevant to the audit and, in doing so, should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel. (See chapter 5 of this guide for further discussion of the components of internal control.) To provide a basis for designing and performing further audit procedures, paragraph .26 of AU-C section 315 states that the auditor should identify and assess the risks of material misstatement at the financial statement level and the relevant assertion level for classes of transactions, account balances, and disclosures.
7.148 Effective controls, as they relate to financial reporting of investments in securities, should provide assurance that
a. management’s policies are adequate to provide for financial reporting in accordance with GAAP;
b. physical securities are on hand or held in custody or safekeeping by others in accordance with management's authorization;
c. misstatements caused by error or fraud in the processing of accounting information for investments in securities are prevented or detected, and corrected in a timely manner;
d. securities are monitored on an ongoing basis to determine whether recorded financial statement amounts necessitate adjustment, including other than temporary impairment; and
e. the presentation and disclosure of the fair value measurements of investment securities are in accordance with GAAP.
7.149 Control activities that would contribute to internal control over financial reporting in this area include the maintenance of management policies, adopted by the those charged with governance or its investment committee, that establish authority and responsibility for investments in securities.
7.150 Other control activities that contribute to strong internal control over financial reporting of securities include the following:
• Procedures exist to identify and monitor credit risk, prepayment risk, and impairment.
• Those charged with governance — generally through an investment committee — oversee management's securities activities.
• Accounting entries supporting securities transactions are periodically reviewed by supervisory personnel to ensure that classification of securities was made and documented at acquisition (and date of transfer, if applicable) and is in accordance with the institution's investment policy and management's intent.
• Recorded securities are periodically reviewed and compared to safekeeping ledgers and custodial confirmations, on a timely basis, including immediate and thorough investigation and resolution of differences and appropriate supervisory review and approval of completed reconciliations.
• Current fair values of securities are determined in accordance with GAAP and reviewed on a timely basis.
• Securities loaned to other entities or pledged as collateral are designated as such in the accounting records.
• Lists of authorized signers are reviewed and updated periodically, and transaction documentation is compared to the authorized lists.
• There is appropriate segregation of duties among those who (a) execute securities transactions, (b) approve securities transactions, (c) have access to securities, and (d) post or reconcile related accounting records.
• Buy and sell orders are routinely compared to brokers' advices.
• Adjustments to securities accounts (for example, to recognize impairments) are reviewed and approved by the officials designated in management's policy.
• Periodic tests of interest and dividend income are performed by reference to supporting documentation, which may include using analytical procedures commonly referred to as yield analysis. (With this approach, actual yields during the period are compared to expected yields based on previous results and current market trends. Any significant differences should be investigated and explained.)
• Management maintains frequent, open dialogue with any third-party investment advisors as to the company’s strategy and how that impacts investment decisions.
• Securities are monitored on an ongoing basis and factors affecting income recognition and the carrying amount of the securities are analyzed periodically to determine whether adjustments are necessary.
7.151 AU-C section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures, addresses the auditor’s responsibilities relating to accounting estimates, including fair value accounting estimates and related disclosures, in an audit of financial statements. Specifically, it expands on how AU-C section 315; AU-C section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained; and other relevant AU-C sections are to be applied with regard to accounting estimates. It also includes requirements and guidance related to misstatements of individual accounting estimates and indicators of possible management bias.
7.152 When performing risk assessment procedures and related activities to obtain an understanding of the entity and its environment, including the entity’s internal control, as required by AU-C section 315, paragraph .08 of AU-C section 540 states that the auditor should obtain an understanding of the following in order to provide a basis for the identification and assessment of the risks of material misstatement for accounting estimates:32
a. The requirements of the applicable financial reporting framework relevant to accounting estimates, including related disclosures.
b. How management identifies those transactions, events, and conditions that may give rise to the need for accounting estimates to be recognized or disclosed in the financial statements. In obtaining this understanding, the auditor should make inquiries of management about changes in circumstances that may give rise to new, or the need to revise existing, accounting estimates.
c. How management makes the accounting estimates and the inputs on which they are based, including
i. the method(s), including, when applicable, the model, used in making the accounting estimate;
ii. relevant controls;
iii. whether management has used a specialist;
iv. the assumptions underlying the accounting estimates;
v. whether there has been or ought to have been a change from the prior period in the method(s) or assumption(s) for making the accounting estimates and, if so, why; and
vi. whether and, if so, how management has assessed the effect of estimation uncertainty.
See paragraphs .A11–.A37 of AU-C section 540 for additional application guidance and other explanatory material as it relates to accounting estimate risk assessment procedures and related activities.
7.153 Many of the control activities for securities are often performed directly by senior management. Although management's close attention to securities transactions can be an effective factor in internal control, in accordance with paragraph .15 of AU-C section 240, Consideration of Fraud in a Financial Statement Audit, the engagement team should address the risk of management override of controls during the discussion among the key engagement team members.
7.154 AU-C section 330 addresses the auditor’s responsibility to design and implement responses to the risks of material misstatement identified and assessed by the auditor in accordance with AU-C section 315 and to evaluate the audit evidence obtained in an audit of financial statements.
7.155 In accordance with paragraph .08 of AU-C section 330, the auditor should design and perform tests of controls to obtain sufficient appropriate audit evidence about the operating effectiveness of relevant controls if (a) the auditor’s assessment of risks of material misstatement at the relevant assertion level includes an expectation that the controls are operating effectively or (b) substantive procedures alone do not provide sufficient appropriate audit evidence at the relevant assertion level. Examples of tests of controls that might be considered include
• reading minutes of meetings of the board of directors (and any investment committee), or attending a meeting of the board of directors or investment committee, for evidence of the board's periodic review of securities activities made so that the board may determine adherence to the institution's policy;
• comparing securities transactions, including transfers, to the institution's accounting policy to determine whether the institution is following its policy. For example, the independent accountant may include
— testing that transactions have been executed in accordance with authorizations specified in the investment policy;
— evaluating evidence that securities portfolios and related transactions (including impairments) are being monitored on a timely basis and reviewing supporting documentation; and
— testing recorded purchases of securities, including classification of the securities, prices, and entries used to record related amounts (for example, use of trade versus settlement date, treatment of commissions, and premiums and discounts).
• recalculating a sample of premium and discount amortization amounts and gains and losses on sales;
• reviewing controls over accumulating information necessary for financial statement disclosures;
• testing the reconciliation process. The independent accountant might test whether reconciling differences are investigated and resolved and whether the reconciliations are reviewed and approved by supervisory personnel; and
• examine evidence that the company takes physical inventory and confirms safekeeping on a periodic basis, including reconciliation of differences.
7.156 Many financial institutions outsource the determination of fair value measurements of investment securities to third party service organizations, such as a pricing service. AU-C section 402, Audit Considerations Relating to an Entity Using a Service Organization, addresses the user auditor’s responsibility for obtaining sufficient appropriate audit evidence in an audit of the financial statements of a user entity that uses one or more service organizations. Specifically, it expands on how the user auditor applies AU-C sections 315 and 330 in obtaining an understanding of the user entity, including internal control relevant to the audit, sufficient to identify and assess the risks of material misstatement and in designing and performing further audit procedures responsive to those risks. If the user auditor plans to use a type 2 report as audit evidence that controls at the service organization are operating effectively, paragraph .17 of AU-C section 402 states that the user auditor should determine whether the service auditor’s report provides sufficient appropriate audit evidence about the effectiveness of the controls to support the user auditor’s risk assessment by
a. evaluating whether the type 2 report is for a period that is appropriate for the user auditor’s purposes;
b. determining whether complementary user entity controls identified by the service organization are relevant in addressing the risks of material misstatement relating to the relevant assertions in the user entity’s financial statements and, if so, obtaining an understanding of whether the user entity has designed and implemented such controls and, if so, testing their operating effectiveness;
c. evaluating the adequacy of the time period covered by the tests of controls and the time elapsed since the performance of the tests of controls; and
d. evaluating whether the tests of controls performed by the service auditor and the results thereof, as described in the service auditor's report, are relevant to the assertions in the user entity's financial statements and provide sufficient appropriate audit evidence to support the user auditor's risk assessment.
7.157 The auditor may also consider the following, which is not intended to be an all-inclusive list of considerations:
• Whether the pricing service determines fair value measurements in accordance with the requirements of FASB ASC 820?
• If trades of identical securities in an active market are available, are the pricing service’s fair value estimates equal to quoted market prices?
• For trades of identical securities, does the third party pricing service evaluate whether or not the market is active?
• What is the criteria used to evaluate whether the market is active?
• When a model is used to determine fair value, does the pricing service maximize the use of observable inputs and minimize the use of unobservable inputs?
7.158 Irrespective of the assessed risks of material misstatement, paragraph .18 of AU-C section 330 states that the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure, which for a financial institution would include investments in debt and equity securities. In accordance with paragraph .A45 of AU-C section 330, this requirement reflects the facts that (a) the auditor’s assessment of risk is judgmental and may not identify all risks of material misstatement and (b) inherent limitations to internal control exist, including management override.
7.159 AU-C section 501 addresses specific considerations by the auditor in obtaining sufficient appropriate audit evidence, in accordance with AU-C section 330; AU-C section 500, Audit Evidence; and other relevant AU-C sections, regarding, among other considerations, certain aspects of investments in securities and derivative instruments in an audit of financial statements. In addition, the companion AICPA Audit Guide Special Considerations in Auditing Financial Instruments specifically addresses derivatives and securities measured or disclosed at fair value, various methods for determining fair value as specified by GAAP, and evaluating audit evidence for the valuation assertion of derivatives and securities. Readers may consider this guidance when designing and performing substantive tests.
7.160 Paragraph .06 of AU-C section 540 states that the objective of the auditor is to obtain sufficient appropriate audit evidence about whether, in the context of the applicable financial reporting framework,
a. accounting estimates, including fair value accounting estimates, in the financial statements, whether recognized or disclosed, are reasonable; and
b. related disclosures in the financial statements are adequate.
7.161 Based on the assessed risks of material misstatement, paragraph .12 of AU-C section 540 states that the auditor should determine
a. whether management has appropriately applied the requirements of the applicable financial reporting framework relevant to the accounting estimate;
b. whether the methods for making the accounting estimates are appropriate and have been applied consistently; and
c. whether changes from the prior period, if any, in accounting estimates or the method for making them are appropriate in the circumstances.
7.162 In responding to the assessed risks of material misstatement, as required by AU-C section 330, paragraph .13 of AU-C section 540 states that the auditor should undertake one or more of the following, taking into account the nature of the accounting estimate:33
a. Determine whether events occurring up to the date of the auditor’s report provide audit evidence regarding the accounting estimate.
b. Test how management made the accounting estimate and the data on which it is based. In doing so, the auditor should evaluate whether
i. the method of measurement used is appropriate in the circumstances,
ii. the assumptions used by management are reasonable in light of the measurement objectives of the applicable financial reporting framework, and
iii. the data on which the estimate is based is sufficiently reliable for the auditor’s purposes.
c. Test the operating effectiveness of the controls over how management made the accounting estimate, together with appropriate substantive procedures.
d. Develop a point estimate or range to evaluate management’s point estimate. For this purpose
i. if the auditor uses assumptions or methods that differ from management’s, the auditor should obtain an understanding of management’s assumptions or methods sufficient to establish that the auditor’s point estimate or range takes into account relevant variables and to evaluate any significant differences from management’s point estimate.
ii. if the auditor concludes that it is appropriate to use a range, the auditor should narrow the range, based on audit evidence available, until all outcomes within the range are considered reasonable.
7.163 In determining the matters identified in paragraph .12 of AU-C section 540 (see paragraph 7.161) or in responding to the assessed risks of material misstatement in accordance with paragraph .13 of AU-C section 540 (see paragraph 7.162), paragraph .14 of AU-C section 540 states that the auditor should consider whether specialized skills or knowledge with regard to one or more aspects of the accounting estimates are required in order to obtain sufficient appropriate audit evidence. Depending on the auditor’s understanding of, and experience working with, the auditor’s specialist or those other individuals with specialized skills or knowledge, paragraph .A107 of AU-C section 540 states that the auditor may consider it appropriate to discuss matters such as the requirements of the applicable financial reporting framework with the individuals involved to establish that their work is relevant for audit purposes.
7.164 Auditing interests in trusts held by a third-party trustee and reported at fair value. In circumstances in which the auditor determines that the nature and extent of auditing procedures should include verifying the existence and testing the measurement of investments held by a trust, simply receiving a confirmation from the trustee, either in aggregate or on an investment-by-investment basis, does not in and of itself constitute adequate audit evidence with respect to the requirements for auditing the fair value of interests in trusts under AU-C section 540. In addition, receiving confirmation from the trustee for investments in aggregate does not constitute adequate audit evidence with respect to the existence assertion. Receiving confirmation from the trustee on an investment-by-investment basis, however, typically would constitute adequate audit evidence with respect to the existence assertion. Also, in discussing obtaining an understanding of how management identifies the need for accounting estimates, paragraph .A15 of AU-C section 540 states that the preparation and fair presentation of the financial statements requires management to determine whether a transaction, an event, or a condition gives rise to the need to make an accounting estimate and that all necessary accounting estimates have been recognized, measured, and disclosed in the financial statements in accordance with the applicable financial reporting framework.
7.165 In circumstances in which the auditor is unable to audit the existence or measurement of interests in trusts at the financial statement date, the auditor should consider whether that scope limitation requires the auditor to either qualify his or her opinion or to disclaim an opinion, as discussed in AU-C section 705, Modifications to the Opinion in the Independent Auditor’s Report.
Considerations for Audits Performed in Accordance With PCAOB Standards34
PCAOB Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists (PCAOB Staff Guidance, sec. 400.02), provides guidance on auditors' responsibilities for auditing fair value measurements of financial instruments and when using the work of specialists under the existing standards of the PCAOB. This alert is focused on specific matters that are likely to increase audit risk related to the fair value of financial instruments in a rapidly changing economic environment. This practice alert highlights certain requirements in the auditing standards related to fair value measurements and disclosures in the financial statements and certain aspects of GAAP that are particularly relevant to the economic environment.
PCAOB Staff Audit Practice Alert No. 4, Auditor Considerations Regarding Fair Value Measurements, Disclosures, and Other-Than-Temporary Impairments (PCAOB Staff Guidance, sec. 400.04), informs auditors about potential implications of FASB guidance on reviews of interim financial information and annual audits. This alert addresses the following topics: (a) reviews of interim financial information; (b) audits of financial statements, including integrated audits; (c) disclosures; and (d) auditor reporting considerations.
In accordance with “Pending Content” in FASB ASC 321-10-20, equity securities are defined as any security representing an ownership interest in an entity (for example, common, preferred, or other capital stock) or the right to acquire (for example, warrants, rights, forward purchase contracts, and call options) or dispose of (for example, put options and forward sale contracts) an ownership interest in an entity at fixed or determinable prices. Debt securities, as defined in FASB ASC 320-10-20, are any securities that represent a creditor relationship with an entity, such as treasury securities or corporate bonds.
FASB Accounting Standards Update (ASU) No. 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, issued in January 2016, is effective for fiscal years, and interim periods within those fiscal years, of a public business entity beginning after December 15, 2017. For all other entities (including not-for-profit entities and employee benefit plans within the scope of FASB ASC 960 through FASB ASC 965 on plan accounting), FASB ASU No. 2016-01 is effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Additional effective date guidance is included in the ASU. Readers are encouraged to read the full text of the ASU, available at www.fasb.org. Readers should apply the appropriate guidance based on their facts and circumstances.