In accordance with the Emerging Issues Task Force's EITF 99-20, starting first quarter 2001, new accounting guidelines will impact the recognition of interest income on credit- and prepayment-sensitive securitized assets, usually associated with residuals and interest-only strips (including agency IOs).
Further, a semi-controversial impairment accounting provision, which takes into affect factors such as prepayment risk, could cause bond holders to write-down certain high quality assets that would not have been written down under the previous impairment guidelines, according to Hee H. Lee, a senior manager at Ernst & Young.
"In this particular case, a lot of people think that the task force went beyond its authority," said another source following the developments. "Some people view 99-20 as a change in accounting, as opposed to interpreting the existing accounting."
The EITF 99-20 deals with two areas of residual accounting, interest recognition for residual accounting, as well as the impairment accounting clause, which determines how to recognize a non-temporary decline in fair (or market) value on a residual asset.
For the interest recognition piece, under prior guidance, EITF 89-4, interest income was accounted for using a retrospective method. The retrospective method recognizes interest income on a cash basis, where any variance from an expected residual cash flow is recognized as an income gain or loss.
Under EITF 99-20, any variance on residual returns from the estimated returns will be accounted for on a prospective manner, meaning that a change in cash flow is accounted for over the remaining life of the instrument, to capture the variance in future projections.
As for the impairment clause, under the previous guidance, an asset is considered impaired when the internal rate of return calculated is less than the risk-free rate, or the rate paid on a comparable Treasury.
"So under the old guidance, there's a definite threshold, where if you hit the threshold, you're going to be impaired," Lee explained.
However, with EITF 99-20, the concept of "other-than-temporary" decline in value was incorporated into the accounting mechanism. Prepayment risk, which is considered a non-temporary decline in value on senior bonds (which pay out first in a prepayment event), needs to be taken into account for valuation of the instrument.
"If that decline in value is such that the value of the instrument is less than the amortized costs, which is the book value, than you have an impairment, which is troublesome to a lot of people," Lee said.
"I don't think it's going to stop people from doing deals," said Joe Donovan, group co-head of asset-backed finance at Credit Suisse First Boston. Donovan noted that EITF 99-20 is part of an overall trend towards mark-to-market accounting.
"It will encourage people to sell residuals," he added.
The EITF is the accounting team that deals with all "pressing" industry issues. The group meets regularly, usually with five to ten issues on the agenda for discussion.
Most recently, the task force issued EITF 00-19, a resolution for accounting for mezzanine instruments, which clarifies what is considered an equity instrument and what is considered debt.