Earnings Quality, Off-Balance Sheet Risk, and the Financial-Components Approach to Accounting for Transfers of Financial Assets

Abstract

Two standard setting approaches have emerged globally to guide the choice of accounting for securitizations: the control and components approach (FAS125/FAS140) and the risks and rewards transfer approach (IAS39). A lack of consensus about derecognition accounting is a major impediment to achieving convergence in global standards that must be resolved. Thus, both FAS140 and IAS39 will be re-examined and evidence pertinent to the debate is timely and important. In this study, we present evidence consistent with the view of credit rating analysts, who view securitizations as in substance secured borrowings. Specifically, for a sample of originators applying sale accounting guidance in FAS125 during the period 1997-2000, we show that off-balance sheet debt related to securitizations has the same risk relevance for explaining market measures of risk (i.e., CAPM beta) as on-balance sheet debt. We also find that securitization gains receive a lower pricing multiple, relative to net income excluding such gains, and in particular, the pricing multiple declines as the amount of off-balance sheet debt increases, implying increasing skepticism of investors about the valuation relevance of front-end-loaded gains on sale as the extent of off-balance sheet financing activity related to securitizations increases. It would appear that current gain recognition is premature for the high levels of financial leverage implicit in many securitization deals.