West Pacific (WP) is a financial institution incorporated in 1997 and traded on the Toronto Stock Exchange. Its performance has been exceptional since the original issue. Your firm of chartered accountants has been the auditor for WP since its inception. It is now December 2012.
Across Canada, WP has 200 offices that issue residential mortgages. All mortgages issued are insured by Canada Mortgage and Housing Corporation (CMHC). All CMHC- approved issuers must grant mortgages in accordance with policies that CMHC has developed to protect the quality of the mortgages. A qualified borrower can seek a mortgage for up to 95% of the value of the property, and WP will grant the funds since CMHC promises to pay principal and interest in the event of default. For this arrangement, the borrower pays a fee to CMHC.
WP initially records the mortgages as receivables. When WP has $50 million in mortgages with similar terms (e.g., 4‘/i to 5-year term, paying 9 to 9.5% interest), it pools the mortgages and sells the pool to investors. At this point, WP removes the mortgages from its books. The borrower continues to make payments to WP, which passes them on to the investors less a 0.6% fee, which WP retains. The investor’s interest in this mortgage pool is called a mortgage-backed security (MBS).
Besides the CMHC guarantee on the individual mortgages, WP provides a guarantee of timely payment to the investor in the event of default. The MBS therefore entails almost no risk for the investor and is considered to be as safe as Government of Canada bonds. Since the mortgage-backed security yields about 0.5% more than government bonds, it has enjoyed tremendous success in the marketplace.
WP has no problem selling the security but it may take several months to accumulate the pool of mortgages it wishes to sell. After a pool of mortgages has been raised, it can take an additional three months to sell the pool to investors, due to the administration involved. During this period, WP is exposed to changes in interest rates.
WP's ratio of assets to equity must not exceed 25 times. WP provides a monthly financial statement to the federal financial institution regulator that monitors this ratio.
Since 1997, WP has been a leader in establishing the accounting rules in this evolving area. Its vice-president of finance is proud of the policies it has adopted. The Ontario Securities Commission (OSC) has started a program to review annual reports and is now questioning some of the company’s accounting policies, even though there are no specific regulations covering these policies. Concerns raised by the Ontario Securities Commission are as follows:
1. The OSC questions whether mortgage receivables should be removed from the balance sheet when the company issues the MBSs.
2. The OSC disagrees with WP's policy of recognizing the present value of the 0.6% fee it earns on each mortgage as revenue when an MBS is sold.
3. Unsold mortgage receivables held at year-end remain on WP’s books at cost and are not revalued because they will be sold in the short term. The OSC does not agree with this practice.
Required:
Provide arguments that support WP's position on the accounting policies being questioned and the arguments that the OSC could present to support its position. Be specific in your arguments. (For example, "policy X is more relevant” would be too general.)