National Bank Appeals Process:
Appeal of Accounting Decision - (Fourth Quarter 2002)
A bank
appealed two OCC decisions regarding the accounting treatment for
income earned and expenses incurred from two separate affinity card
relationships. The
issues involved the bank's contractual agreements with an affinity
group (contract no. 1) and an affiliate (contract no. 2),
respectively, and are individually discussed below.
Contract
No. 1
Background
The
bank purchased an existing affinity portfolio from another
institution at a premium.
The contract with the affinity association required an
advance at signing and minimum annual payments (royalty
expense). The bank
computed the expenses associated with the contract based on a
formula that allocated most of the expense to the latter years of
the contract because of the belief that the economics of the program
would improve over time.
The bank recorded the difference between the minimum payments
and the formula expense as a prepaid asset.
Discussion
The OCC and
the bank agreed that the guiding standards fell under generally
accepted accounting principles (GAAP), and the Financial Accounting
Standards Board Statement of Financial Accounting Concepts (No. 5),
which requires that expenses be allocated in a systematic and rational
manner during the period in which the related assets are expected to
provide benefits.
In
determining the criteria of systematic and rational, the bank
considered the totality of the agreement with the recognition of
royalty expenses, which include the amortization of the purchase
premium. The premium
for the portfolio reflected the benefit in prior years of the
affinity group's endorsements compared to the benefits enjoyed from
royalty payments in later years. The bank believed that the
combination of royalty expense and premium amortization resulted in
a reasonably consistent charge against receivables. Escalation of royalty fees
paid to the affinity group mirrored the improving economics of the
program over time. The
bank's external auditors agreed that the bank's approach was
systematic and rational.
The
OCC concluded that a systematic and rational approach was one that
recognized periodic expense in relationship to the average revolving
receivable balances in the corresponding period. Based on the bank's
projections, the OCC determined that an amortization rate of between
1.1 and 1.3 percent of average revolving balances would provide this
level relationship. The OCC estimated that such a method would
reduce the prepaid balance by almost 75 percent and directed the
bank to charge off this amount.
Conclusion
The
accounting standards and principles relevant to this transaction are
not specific.
Therefore, when considering the bank's and the OCC's methods,
it was believed that there existed a legitimate difference of
opinion regarding a systematic and rational
approach to accounting for this complex transaction. The ombudsman clearly
acknowledged that there could be different judgments made, and
different conclusions reached, on the asset valuations. Therefore, the ombudsman
opined that the most appropriate resolution of this difference of
opinion rested with the Securities and Exchange Commission (SEC)
accounting division.
The bank was directed to contact the SEC to discuss the
accounting treatment for this transaction.
Contract
No. 2
Background
In
a separate agreement the affinity group's affiliate agreed to pay
the bank a percentage of the shortfall if a specified rate of return
was not met. This gross
profit adjustment was recorded as a prepaid asset. This receivable was recorded
during the early years of the contract but was not payable by the
affiliate until the expiration of the 16-year contract.
Discussion
The bank
believed that the prepaid asset was fully bankable, based on the
unconditional contractual obligation of the affiliate, and therefore
carried it at full value.
The OCC concluded that the bank's accounting treatment for
this asset was inappropriate.
The OCC considered this prepaid asset to be a gain
contingency, and as such, under GAAP it should not be recognized
until payment is realized.
The bank was of the opinion that the asset had economic
value, and therefore, the OCC should not impose an accounting
treatment that assigns no value.
Conclusion
In
considering all of the dimensions of the prepaid asset, the
ombudsman opined that it was appropriate to recognize the
revenue. However, in
light of the extended time period required to receive payment, it
would have been more appropriate to record the prepaid asset at a
discounted value.
Therefore, the bank was directed to adjust its books to
reflect the discounted value of the asset for each of the periods in
question and amend the call reports as appropriate.
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