Creative Choice Corporation (CC) is a publicly traded company that has been providing traditional mortgage loans for the past 10 years. In an effort to grow its business, it has decided to build another five banking service locations across the country. The expected cost of construction is around $10 million. The company contracted to build the new banks requires a $2-million retainer upfront before it begins construction.

To accelerate cash flow, CC pooled outstanding mortgage loans for a value of $2 million and transferred them to a newly created special purpose entity (the trust). The trust in turn has sold mortgage-backed securities to third-party investors for cash. CC will continue to service and man- age the mortgage receivables sold, including collecting the principal and interest payments from customers and remit- ting cash to the trust for payment to investors. An annual fee of $25,000 will be earned by CC for servicing and collecting the mortgage receivables. The fee will be paid as a reduction of the returns earned on the securities.

As part of the agreement, CC is still responsible to pay the full payment to investors even when a customer defaults on a mortgage payment. This recourse obligation, or the liability that CC may be at risk of incurring as a result of any mortgage payments not collected, has an estimated fair value of 2% of the mortgage receivables at year end, based on CC's historical payment defaults. The majority of pooled mortgage receivables sold have adjustable rates after five years, meaning the interest rate charged on the mortgage may increase if there is an overall increase in interest rates.

At the beginning of the year, CC loaned $133,500 to a smaller independent bank in exchange for a two-year, $150,000 non-interest-bearing note. The note's present value is $133,500. CC has recorded the note receivable at $150,000. No interest has been recorded in relation to the note receivable.

In the last quarter, customer mortgage defaults have increased by 1 percentage point over the 2% historical rate. With a 1-percentage-point increase in market interest rates chargeable on the mortgage expected over the next quarter, CC expects an another increase of 1-percentage point in the default rate next quarter.

An excerpt of the note for the mortgage receivables is provided below.

Mortgage loans (pooled and sold) ............................. $ 2,000,000

Mortgage loans, net of allowance .............................. 45,700,000

Mortgage servicing asset .................................................... 0

Accrued interest receivable .......................................... 15,000

CC uses credit lines from a larger independent bank to finance the majority of its mortgage lending practice. Given the recent changes in economic conditions, the bank has been monitoring CC's liquidity. As such, CC is subject to certain covenants, including a debt to equity ratio of no more than 2 to 1. Prior to pooling the mort- gage receivables, CC's debt to equity ratio was 1.8 to 1. The majority of mortgage loans that remain on the balance sheet have also been pledged as collateral to the bank

Instructions

It is now the week after month end and you are reviewing the current-year results. Assume the role of the controller and discuss the financial reporting issues. Provide journal entries when appropriate.