The recognition and de-recognition requirements of IAS 39 were not changed when they were incorporated into IFRS 9, other than that a paragraph was added into IFRS 9 clarifying when a financial asset should be written off. This chapter therefore covers the requirements of both standards. However, in respect of the related area of modifications, in 2017 the IASB confirmed how modifications of financial liabilities that do not result in de-recognition should be treated under IFRS 9, which might result in a change in practice from IAS 39.
The contractual provisions underlying financial assets or financial liabilities determine the rights or obligations. An entity only recognises a financial asset or a financial liability at the time it becomes a party to a contract because that is the point at which it has contractual rights or obligations.
An entity considers whether it still has an asset or liability when considering de-recognition The entity determines whether the rights or obligations contained in the original asset or liability cease to be contractual rights or obligations.
Unconditional receivables and payables are recognised as assets or liabilities when the entity becomes a party to the contract and has a legal right to receive or a legal obligation to pay cash.
An entity that becomes a party to a forward contract within IAS 39/ IFRS 9’s scope, becomes exposed to risks and benefits at the contract commitment date, rather than on the date on which settlement takes place. At the commitment date, the fair values of the right and obligation are often equal, so that the net fair value of the forward contract is zero. If the net fair value of the right and obligation is not zero at inception, the contract is recognised as an asset or liability. A forward contract that has a zero fair value at inception could become a net asset or liability in the future, depending on the value of the underlying instrument or commodity that is the subject of the forward.
Option contracts within IAS 39/ IFRS 9’s scope are recognised as assets or liabilities when the holder or writer becomes a party to the contract. Evidence that entities have become parties to the contract is that the option holder usually pays, and the option writer usually receives, a premium for the contract. The premium indicates that the rights and obligations undertaken by each party have value at that date.
An entity that enters into a firm commitment to purchase a nonfinancial asset in the future, does not yet have the contractual rights to that asset. The entity cannot use that asset, sell it or pledge it as collateral until the contract matures and the underlying asset is acquired. Therefore, assets to be acquired and liabilities to be incurred as a result of a firm commitment to purchase or sell goods or services are generally not recognised as assets or liabilities until at least one of the parties has performed under the agreement.
Firm commitments to buy or sell non-financial assets
An entity that receives a firm order to buy or sell a non-financial asset does not generally recognise an asset for the consideration to be received at the time of the commitment. Instead, it delays recognition until the ordered goods or services have been shipped, delivered or rendered. Similarly, the entity that places the order does not recognise a liability for the consideration to be paid until that point.
Contracts to buy or sell non-financial assets that can be settled net or by exchanging financial instruments are treated as if they are financial instruments (see chapter 40 para 53). Those financial instruments are derivatives, unless they were entered into and continue to be held to meet the entity’s normal purchase, sale or usage requirements. The net fair value of the contract itself is recognised as an asset or liability at the commitment date if the instrument is a derivative.
If a previously unrecognised firm commitment is designated as a hedged item in a fair value hedge, any change in the net fair value attributable to the hedged risk should be recognised as an asset or liability after the inception of the hedge.
Hedges of firm commitments
Some argue that it is conceptually incorrect to recognise an asset or liability for a firm commitment because it has been hedged. The IASB explains in the Basis of Conclusions that the only difference between a firm commitment that is not hedged and one that is hedged is that the latter is remeasured for changes in the hedged fair value, while the former is measured at its historical cost of zero. Therefore, there is no fundamental difference in concept as far as recognition is concerned.
Planned future transactions, no matter how likely, cannot give rise to financial assets and liabilities because the entity has not become a party to a contract. Future transactions are events to be recognised in the future periods when contractual rights are acquired or obligations incurred.
A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose terms require delivery of the asset within a certain time frame. That timeframe is generally established by regulation or convention in the marketplace concerned.
A marketplace is the environment in which a financial asset is customarily exchanged and is not limited to a formal stock exchange or organised over-the-counter market. An acceptable time frame in a marketplace is the period reasonably and customarily required for the parties to complete the transaction, and to prepare and execute closing documents.
A settlement mechanism exists in many regulated financial markets, with transactions in financial instruments (particularly quoted equities and bonds) settled a few days after the transaction date. The date on which the transaction is entered into is called the ‘trade date’. It is the date on which the entity commits to purchase or sell an asset. The date on which the transaction is settled by delivery of the underlying asset is called the ‘settlement date’.
Settlement mechanism for regular-way transactions
The standard settlement periods on the London Stock Exchange for equity market securities and wholesale gilts are trade date plus 3 business days (T+3) and trade date plus 1 business day (T+1) respectively.
A contract to buy or sell a financial asset with an individual or through a broker that is normally traded on a regulated financial market, but with a settlement period that differs from that established by regulation or convention in that financial marketplace, does not qualify as a regular way transaction.
A regular way purchase or sale that results in a fixed-price commitment between trade date and settlement date is a derivative – a forward contract. A regular way purchase or sale would be recognised as a forward contract at the commitment date – that is, the trade date. The short duration of the commitment means that such contracts are not recognised as derivative financial instruments under IAS 39/ IFRS 9 (see paras 44.2 to 44.23). This is an exception to normal recognition rules.
Practical expedients
The short duration of the difference between the trade and settlement dates of regular way purchases and sales means that the forward contracts that they generate are not recognised as derivatives. This is a practical expedient, to prevent the recognition of derivatives for short periods where the marketplace mechanism prevents settlement at the trade or commitment date.
The exception also removes a potential distortion that would occur by recognising changes in fair value of the asset between trade and settlement date through profit or loss, when such changes in fair value after settlement date would either not be recognised at all (where the financial asset will be measured at amortised cost), or they would be recognised in other comprehensive income (where the financial asset will be measured at fair value through other comprehensive income).
The regular way exception requires that the transaction will be settled by physical delivery of the financial instrument within the normal market time frame. A contract that permits net settlement in cash or other financial assets equivalent to the change in the contract’s fair value does not qualify as a regular way transaction. These contracts are accounted for as a derivative in the period between trade and settlement date. Contracts that are settled outside the normal market time frame, whether settled net in cash or gross, will always be accounted for as derivatives.
A regular way purchase or sale of financial assets should be recognised and de-recognised using trade date accounting or settlement date accounting. Either method is acceptable. It is an accounting policy choice that should be disclosed and applied consistently for all purchases and sales that belong to the same category of financial assets.
Trade date accounting (that is, the date on which an entity commits itself to purchase or sell an asset) is as follows:
Generally, interest does not start to accrue on the asset and corresponding liability until settlement date when title passes.
Regular way purchase of a financial asset
On 29 December 20X5, an entity commits to purchase a financial asset for C1,000, which is its fair value on commitment (trade) date. Transaction costs are immaterial. On 31 December 20X5 (financial year-end) and on 4 January 20X6 (settlement date) the fair value of the asset is C1,002 and C1,003, respectively. The amounts to be recorded for the asset will depend on how it is classified and whether trade date or settlement date accounting is used, as shown in the two tables below:
Trade date accounting
Details Assets carried at amortised cost Assets at fair value through other comprehensive income Assets at fair value through profit or loss C C C 29 December 20X5 Dr Financial asset 1,000 1,000 1,000 Cr Liability for payment to record asset and liability for payment (1,000) (1,000) (1,000) 31 December 20X5 Dr Financial asset – 2 2 Cr Other comprehensive income – (2) – Cr Profit or loss to recognise change in fair value – – (2) 4 January 20X6 Dr Financial asset – 1 1 Cr Other comprehensive income – (1) – Cr Profit or loss to recognise change in fair value – – (1) 4 January 20X6 Dr Liability for payment 1,000 1,000 1,000 Cr Cash to record settlement of liability (1,000) (1,000) (1,000) Asset’s carrying value at 4 January 20X6 1,000 1,003 1,003
Settlement date accounting
Details Assets carried at amortised cost Assets at fair value through other comprehensive income Assets at fair value through profit or loss C C C 29 December 20X5 No entries are recorded at the commitment date 31 December 20X5 Dr Financial asset – 2 2 Cr Other comprehensive income – (2) – Cr Profit or loss to recognise change in fair value – – (2) 4 January 20X6 Dr Financial asset – 1 1 Cr Other comprehensive income – (1) – Cr Profit or loss to recognise change in fair value – – (1) 4 January 20X6 Dr Liability for payment 1,000 1,000 1,000 Cr Cash to record settlement of the asset’s purchase at the contracted cash amount plus changes in fair value since trade date. (1,000) (1,000) (1,000) Asset’s carrying value at 4 January 20X6 1,000 1,003 1,003
Regular way sale of a financial asset
On 29 December 20X5 (trade date), an entity enters into a contract to sell a financial asset (a debt investment) for its current fair value of C1,010. The asset was acquired one year earlier for C1,000 and its amortised cost is C1,000. On 31 December 20X5 (financial year end), the fair value of the asset is C1,012. On 4 January 20X6 (settlement date), the fair value is C1,013. The amounts to be recorded will depend on how the asset is classified and whether trade date or settlement date accounting is used, as shown in the two tables below (any interest that might have accrued on the asset is disregarded):
Trade date accounting
Date Assets carried at amortised cost Assets at fair value through other comprehensive income Assets at fair value through profit or loss C C C Carrying value prior to 29 December 20X5 1,000 1,010 1,010 29 December 20X5 Dr Receivable 1,010 1,010 1,010 Cr Asset (1,000) (1,010) (1,010) Dr Other comprehensive income 10 – Cr Profit or loss to record disposal of the asset and ‘recycling’ of cumulative gain from other comprehensive income on disposal of the asset that had been recognised in other comprehensive income to profit or loss on trade date. (10) (10) – 31 December 20X5 A change in the fair value of a financial asset that is sold on a regular way basis is not recorded in the financial statements between trade date and settlement date because the seller’s right to changes in the fair value ceases on the trade date. 4 January 20X6 Dr Cash 1,010 1,010 1,010 Cr Receivable to record settlement of sales contract Settlement date accounting (1,010) (1,010) (1,010) 29 December 20X5 Carrying value prior to 29 December 20X5 1,000 1,010 1,010 31 December 20X5 A change in the fair value of a financial asset that is sold on a regular way basis is not recorded in the financial statements between trade date and settlement date, even if the entity applies settlement date accounting, because the seller’s right to changes in the fair value ceases on the trade date. 4 January 20X6 Dr Cash 1,010 1,010 1,010 Cr Asset (1,000) (1,010) (1,010) Dr Other comprehensive income 10 – Cr Profit or loss to record the disposal of the asset and ‘recycling’ of cumulative gain on the asset that had recognised in other comprehensive income to profit or loss on settlement date. (10) (10)
– In summary, a regular way sale is accounted for as a sale on trade date if trade date accounting is used, and on settlement date, if settlement date accounting is used.
Regular way sale of a financial asset for non-cash consideration
On 29 December 20X5 (trade date), entity A enters into a contract to sell note receivable A, which is carried at amortised cost, in exchange for bond B, which will be classified as held for trading and measured at fair value. Both assets have a fair value of C1,010 on 29 December, while the amortised cost of note receivable A is C1,000. Entity A uses settlement date accounting for loans and receivables and trade date accounting for assets held for trading. On 31 December 20X5 (financial year end), the fair value of note receivable A is C1,012 and the fair value of bond B is C1,009. On 4 January 20X6, the fair value of note receivable A is C1,013 and the fair value of bond B is C1,007. The following entries are made:
Dr Cr C C 29 December 20X5 Bond B 1,010 Liability for payment to record the purchase of bond B on the trade date as per entity’s policy of using trade date accounting for assets held for trading. 1,010 31 December 20X5 Profit or loss 1 Bond B to record the change in fair value of bond B from C1,010 to C1,009. 1 4 January 20X6 Liability for payment 1,010 Note receivable A 1,000 Profit or loss to record the disposal of note receivable A and the resultant gain on sale in exchange for bond B on settlement date. 10 Profit or loss 2 Bond B to record the change in fair value of bond B from C1,009 to C1,007. 2
Settlement date accounting (that is, the date on which an asset is delivered to or by an entity), is as follows:
IAS 39/IFRS 9 does not contain any specific requirements about trade date accounting and settlement date accounting for transactions in financial instruments that are classified as financial liabilities. The general recognition and de-recognition requirements for financial liabilities in IAS 39/IFRS 9 therefore apply.
Liabilities are recognised on the date when the entity ‘becomes a party to the contractual provisions of the instrument’. Financial liabilities are de-recognised only when they are extinguished – that is, when the obligation specified in the contract is discharged or cancelled or expires.
There is one set of requirements that apply to the de-recognition of all financial assets, from the simple maturity of an instrument to the more complex securitisation transactions. The standard provides a flow chart that summarises these requirements for evaluating whether, and to what extent, a financial asset is de-recognised. Every transaction should be analysed using the strict sequence set out in the flow chart. There are two separate approaches to de-recognition under IFRS: the ‘risks and rewards’ approach and the ‘control’ approach. The control approach is only used where the risks and rewards approach does not provide a clear answer. So, the risks and rewards approach should be evaluated first.
Many entities establish structured entities, trusts, partnerships, etc. to acquire financial assets before these financial assets, or a portion thereof, are transferred to third-party investors. The transfer of financial assets to such an entity might qualify as a legal sale. However, if the substance of the relationship between the transferor and the structured entity indicates that the transferor controls the structured entity, the transferor should consolidate the structured entity. Entities should determine whether it is the consolidated or the individual entity that is considering whether to derecognise the financial asset. If it is the consolidated entity, the entity should first consolidate all subsidiaries, including any structured entities, in accordance with IFRS 10 (see chapter 26 para 171). It should then apply the de-recognition analysis to the resulting group. If it is the individual entity preparing separate financial statements this step will not need to be considered.
Determine whether the analysis should be applied to a part of a financial asset (or part of a group of similar financial assets) or to a financial asset in its entirety (or a group of similar assets in their entirety). Derecognition rules should be applied to a part of a financial asset (or part of a group of similar financial assets) if, and only if, the part being considered for de-recognition meets one of the following conditions:
Fully proportionate share of specifically identified cash flows Question:
If an entity enters into an arrangement in which the counterparty obtains the rights to a 90% share of interest cash flows from a financial asset (the specifically identified part), the de-recognition rules are applied to that 90% of those interest cash flows. If there is more than one counterparty, it is not necessary for each counterparty to have a proportionate share of the specifically identified cash flows, provided that the transferring entity retains a fully proportionate share. Question Entity S sells goods to entity B for C100. Entity B is required by local tax regulations to deduct C3 from the settlement in the form of withholding tax, and pay this to the tax authorities. The remaining C97 is paid to entity S. Entity S has no responsibility to pay the withholding tax if entity B fails to make the payment. However, entity S can obtain a withholding tax credit only in the event that entity B pays the withholding tax. Entity S transfers the receivable (C97) to a factor, entity F, and retains the rights to the withholding tax credit. Assume that entity S had no obligation to make additional payments to entity F or to the tax authorities in the event that there is any change in tax rates (and hence the net receivable) prior to settlement.
Can the seller classify the net receivable (C97) as a specifically identified cash flow in accordance with IFRS 9?
Solution:
Yes, entity S can treat the C97 as a specifically identified cash flow for the purposes of applying the IAS 39 / IFRS 9 de-recognition analysis. In effect, entity S had two assets: a receivable of C97 from entity B, and a tax credit of C3 (contingent on entity B paying the withholding tax). The right to C97 is unaffected by the payment (or otherwise) of the withholding tax to the tax authorities by entity B.
The de-recognition rules must be applied to the financial asset in its entirety (or to the group of similar financial assets in their entirety) if it is not possible to identify part of a financial asset.
Sale of the first or the last specified amount of cash flows from a financial asset An entity invests in a portfolio of similar five-year interest-bearing loans of C1 million. It then enters into an agreement with a counterparty. It agrees to pay the counterparty the first C0.9 million of cash collected from the portfolio plus interest. In exchange, the entity receives an upfront cash payment from the counterparty. The entity retains the rights to the last C0.1 million plus interest, representing a subordinated interest in the portfolio. In this situation, the entity (transferor) cannot apply the de-recognition requirements to part of the asset. This is because:
· the first C0.9 million of cash flow represents neither a specifically identifiable cash flow nor a fully proportionate (pro rata) share of all or part of the cash flows from the asset (it is not possible to identify the loans in the portfolio from which the first C0.9 million cash flows will arise); and
· any credit losses are borne in the first instance by the entity (transferor) and are not shared proportionally between the parties.
As a result, the de-recognition rules must be applied to the whole asset. If the arrangement resulted in the transfer of 90% of all cash flows from the asset, the de-recognition rules would have been applied only to the proportion transferred (that is, 90%).
Sale of an asset subject to a guarantee
An entity enters into an arrangement to transfer the rights to 90% of the cash flows of a group of receivables. The entity provides a guarantee to compensate the buyer for any credit losses up to 8% of the principal amount of the receivables.
Although the transferor has transferred 90% of all cash flows from the asset, the existence of the guarantee means that the transferor has an obligation that could involve it in repaying some of the consideration received. Therefore, the de-recognition requirements must be applied to the asset in its entirety and not just to the proportion of cash flows transferred.
Sale of an asset for part of its life
An entity enters into an arrangement to transfer the rights to 100% of the cash flows (that is, interest and principal) arising in the last four years of a fixed rate loan receivable with an original maturity of 10 years. The principal is payable in a lump sum in year 10. The entity retains the right to interest cash flows for the first six years.
The entity has transferred the rights to the last four years of cash flows that represent specifically identifiable cash flows (that is, the last four years of interest cash flows and the principal cash flow). Therefore, the derecognition rules should be applied to this identifiable portion.
Sale of a right to receive dividends or sale of shares but retained rights to dividends
Entity A has a holding of shares in entity X (which are recognised at fair value through other comprehensive income). Entity A transfers to entity B the right to receive dividends paid on those shares in the next year. In this situation, the dividends for the next year are specifically identifiable cash flows, and the de-recognition rules should be applied to those dividends.
If entity A had transferred its holding of shares to entity B and retained the right to receive dividends for the next year, the cash flows arising on the transferred asset from the second year to perpetuity are also specifically identifiable cash flows. Therefore, the de-recognition rules would be applied to only that part of the asset.
Once it has been established that the de-recognition rules should be applied to the whole asset (or a group of similar assets) or to the qualifying part or portion, the remaining steps of the flow chart should be applied to that whole or part identified; is referred to as ‘the financial asset’ in the paragraphs that follow.
Step 3 considers whether the contractual rights to the cash flows from the financial asset have expired. If they have, the financial asset is derecognised. In particular, an entity should directly reduce the gross carrying amount of a financial asset where it has no reasonable expectations of recovering a financial asset in its entirety or a portion thereof. A write-off constitutes a de-recognition event.
Expiry of contractual rights to cash flows
In the normal course of business a loan is extinguished by payment of the entire amount due. Therefore, because the debtor has discharged its obligation the lender would de-recognise the financial asset at that date.
A right from a purchased financial option is extinguished because the contractual terms expire without the holder requiring the writer to deliver or purchase the underlying financial asset. The holder of the option would de-recognise the option at that date.
De-recognition of financial asset due to modification of cash flows
A bank enters into a 10-year loan with a borrower (measured at amortised cost or fair value through other comprehensive income). The loan accrues interest at 4%.
At the end of year 8, as a result of an arm’s length renegotiation, the remaining maturity has been modified from two years to 12 years, and the coupon has been revised to 6% to maturity. The borrower is not in any financial difficulty and there is no objective evidence of impairment (under IAS 39)/the loan has not suffered a significant increase in credit risk (under IFRS 9).
In this situation, the bank has surrendered its rights to the 4% coupon for the next two years and the principal repayment in two years’ time; the rights to these cash flows have expired, and, so they should be derecognised. A new 12-year loan should be recognised at fair value on renegotiation, comprising a new principal payment in 12 years’ time and 6% interest coupons for the next 12 years.
If the contractual rights to the cash flows have not expired, an entity assesses if it transfers the cash flows from the asset. Transfer can be achieved only if one of two conditions is met:
Transfer of contractual rights to receive cash flows IAS 39/ IFRS 9 does not explain what is meant by the phrase “transfers the contractual rights to receive the cash flows of the financial asset” . The suggestion is that a transfer occurs when the cash flows from an asset are legally sold or assigned.
Example 1
An entity that has sold a financial asset has transferred its rights to receive the cash flows from the asset. The transferee has unconditional, presently exercisable rights to all the future cash flows. Step 6 should then be assessed to determine whether this transfer meets the de-recognition criteria.
Example 2
An entity enters into an arrangement with a bank for the bank to manage the entity’s securities. The entity transfers the securities into a safe custody account of the bank. The bank receives a management fee for its service. The entity still makes the decisions as to which securities will be sold and when. This transfer of securities to a custodian does not qualify as a transfer of contractual rights, because the bank does not have the rights to the cash flows of the transferred securities. The bank is acting as the entity’s agent.
Example 3
Some types of financial asset (for example, a receivable or a portfolio of receivables), cannot be ‘sold’ in the same way as other types (for example, a bond), but they can be transferred by means of a novation or an assignment. Both novation and assignment generally result in the transfer of contractual rights to receive the financial asset’s cash flows. However, any further conditions or obligations placed on the transferor in an assignment need to be considered, because this might impact this assessment.
Conditions attached to transfers of financial assets
Transfers of financial assets are sometimes subject to conditions such as:
· Provisions relating to the existence and value of transferred cash flows at the date of transfer (for example, warranties relating to a transferred loan that mean the borrower met the specified lending criteria when the loan was advanced and is not in arrears at the date of transfer).
· Conditions relating to the asset’s future performance (for example, that all repayments will be made when due).
Conditions attached to transfers do not affect whether the entity has transferred the contractual rights to receive cash flows. The existence of conditions relating to the asset’s future performance might affect the conclusion related to the transfer of risks and rewards, as well as the extent of any continuing involvement by the transferor in the transferred asset.
Retention of servicing right
A transferor might continue to administer or provide servicing on a financial asset after the transfer of the contractual rights to its cash flows. A transferor might transfer all rights to cash flows, but continue to collect cash flows on behalf of the transferee in a capacity as an agent, rather than for its own benefit. This could occur where the original asset counterparties are notified that their obligation has been legally transferred to the transferee and are requested to pay the cash flows into a bank account for the transferee’s benefit. The transferor continues to act purely as an agent in managing the collection of the transferee’s cash flows.
Determining whether the contractual rights to cash flows have been transferred is not affected by the transferor retaining the role of an agent to administer collection and distribution of cash flows. Therefore, retention of servicing rights by the entity transferring the financial asset does not mean that the contractual rights to receive cash flows have not been transferred. This would also apply in a scenario where the servicer co-mingled cash collections from the transferred assets with its own assets.
Right of offset on transferred assets
Example 1
Entity Q owes C50 to entity R, and entity R owes C40 to entity Q. These amounts are subject to a legal right of offset. Entity R sells the C50 receivable from entity Q to entity S. Entity S agrees that if entity Q exercises its right of offset on the transferred receivable and pays C10, entity R will make a payment of C40 to entity S. Such an arrangement (two-party offset) does not stop the transfer of contractual rights to receive cash flows. The payment made by entity R to entity S, if the right of offset is exercised, merely transfers to entity S the value that entity R obtained when its liability to entity Q was extinguished.
Example 2
Entity F sells a receivable from its customer to entity G. A sub-contractor (a third party) has performed services that have given rise to that receivable for entity F. Entity F owes C20 to the subcontractor for services rendered. The sub-contractor has a right to offset the C20 that it is owed by entity F against the receivable transferred to entity G. As a result, the subcontractor has the unilateral ability to extinguish the contractual rights to receive cash flows from entity F’s original customer. This arrangement prevents the transfer of contractual rights to receive cash flows.
Transferred assets and credit notes
Example 1
An entity’s customer qualifies for a volume discount that is included in the general sales conditions. Volume discounts are provided by way of credit notes, which can be used against any existing or future invoice. Contractual credit notes issued by a transferor do not stop the transfer of contractual rights to receive cash flows. Such credit notes relate to the relationship between the transferor and its customer, and not to the contract that is the receivable. They do not preclude a transfer of the contractual rights to receive cash flows from the original receivable.
Example 2
A warranty is provided on the sale of goods. If the goods are faulty, the warranty allows the customer to return them in a stated time period, for a full refund. The warranty relates to the business risk of the underlying transaction. This affects the existence of the receivable, rather than the associated financial risks. Therefore, the warranty does not prevent a transfer of the contractual rights to receive cash flows from the original receivable. For the same reasons, these conditions are also not taken into account for the risks and rewards test.
Option to repurchase a transferred asset
An asset transfer includes an option for the transferor to repurchase the assets. This option has been included to enable the transferor to repurchase the receivable in a change of circumstances (for example, a change in tax laws). The option does not prevent a transfer of the contractual rights to receive the cash flows from an asset. The option will need to be considered when applying the risks and rewards test and (if applicable) the control test.
Assumption of obligations to pay cash flows to others (pass-through arrangements)
Pass-through arrangements arise where the entity continues to collect cash receipts from a financial asset or, more typically, a pool of financial assets. The entity also assumes an obligation to pass on those receipts to another party, the eventual recipient, which has provided finance in connection with the financial asset. Three conditions (set out in the following paragraphs) have to be met for a transferor to conclude that a pass-through arrangement meets the criteria for a transfer of a financial asset. The financial assets remain on the balance sheet if any one of these conditions is not met. If the criteria are met the entity will also need to assess whether sufficient risks and rewards have been transferred.
Pass-through arrangements
Pass-through arrangements are common in securitisations and subparticipation arrangements. The entity could be the financial asset’s originator, or it could be a group that includes a consolidated special purpose entity (SPE) that has acquired the financial asset from the originator and passes on cash flows to unrelated third-party investors. For example, a transferor that is a trust or SPE might issue beneficial interests in the underlying financial assets to investors but continue to own those financial assets.
The eventual recipient who receives the cash flows in a pass-through arrangement is any party that might receive cash flows from the assets, excluding the transferor. Most often, they are the noteholders that have invested in a group of securitised assets, but they can also be swap counterparties or credit insurers that have an interest in the assets.
Pass-through tests are strict and some securitisation arrangements might fail them.
The effect of meeting all three of the pass-through conditions is that the entity does not have an asset or a liability as defined in the Framework. The entity does not have an asset because it does not have the rights to control or benefit from the cash flows arising from the asset (second and third conditions). It follows that it also does not have a liability. In these situations, the entity acts more as an agent of the eventual recipient, merely collecting cash on its behalf, rather than as the asset’s owner. Accordingly, if the conditions are met, the arrangement is treated as a transfer, and other conditions for de-recognition are considered. Conversely, if the conditions are not met, the entity acts more as the asset’s owner with the result that the asset should continue to be recognised.
De-recognition of loans where pass-through conditions are not met immediately at transaction date
The pass-through criteria might not be met immediately at the date when the transfer arrangement is entered into. If they are all met after a passage of time, the transferred financial assets should be assessed for derecognition at that subsequent date.
On 1 January 20X1, bank A entered into a contract to sell a portfolio of recently originated mortgage loans to specialised mortgage bank B. Bank A continued to hold legal rights to the cash flows from the loans. Management concluded that bank A transferred substantially all the risks and rewards of the loans to bank B, subject to bank B having the right to sell back to bank A any loan on which any payment default occurs on or before 28 February 20X1. This fails the pass-through test, because bank A has an obligation to pay amounts to bank B in excess of cash flows collected from the borrowers, and not just cash flows from the underlying assets. The other conditions are met.
For accounting purposes, the loans will be regarded as transferred to bank B when the right to sell back any defaulted loans expires. The risks and rewards test will be performed when the transfer conditions are met, on 1 March 20X1. If the risks and rewards test is met at that date, this will result in the de-recognition of the loans on 1 March 20X1.
The first condition is that the entity has no obligation to pay amounts to the eventual recipients, unless it collects equivalent amounts from the original asset. Short-term advances by the entity to the eventual recipients with the right of full recovery of the amount lent plus accrued interest from the amounts eventually payable to the eventual recipients at market rates do not violate this condition.
No obligation to transfer funds not collected The first condition ensures that the transferor is not obliged to transfer funds to the transferee that it has not collected. As such, the transferor is not required to fund payments to the eventual recipients. This means that the transferee must bear the late payment risk.
Short-term advances might be made by the transferor in periods where there are:
· shortfalls in collection due to late payments from the asset; or
· differences in the dates of collection from the assets and payments to the eventual recipients.
These short-term advances will not prevent the transaction from being treated as a transfer, provided that: the short-term advances are made at market rates; and those advances, plus any accrued interest, are recoverable. Recovery would be by deduction from the amounts payable to the eventual recipients, or otherwise recoverable in full in the event that cash flows from the assets are insufficient.
De-recognition would be prevented if the transferor was obliged to provide short-term loans at below market rates of interest or interest free loans. This is because the transferor, and not the transferee, would bear the slowpayment risk.
Example – Fixed payments
A manufacturer, entity D, offers a financing scheme for the sale of its office furnishing products. A customer has the option to pay the purchase price and accrued interest, in fixed monthly instalments over a maximum period of 24 months. Entity D agrees to pay to bank E every month a pre-determined amount of cash equal to the instalments due from its customers in exchange for an upfront cash payment. The payment of a fixed amount of cash does not qualify as a pass-through arrangement, because the amounts that entity D is obliged to pay to bank E are not dependent on actual cash collections from its customers/receivables. Entity D is obliged to pay a pre-determined amount of cash calculated at the outset of the contract even if it has not collected the cash from its customers.
Examples of potential pass-through arrangements
Example 1 – One party assumes a contractual obligation to pay cash flows from a financial asset to another party
Entity F enters into an arrangement with a factor, entity G. Entity F agrees to pass on the cash flows that it collects from specified trade receivables to entity G for an upfront payment. Entity F has to transfer the collected cash flows within two working days. Entity F has no obligation to transfer cash to entity G, unless it collects equivalent amounts from the trade receivables.
Entity F is prohibited by the arrangement’s terms from selling or pledging the trade receivables to a third party. The three conditions for a pass-through arrangement are met in this scenario, because entity F:
· retains the contractual rights to receive the financial asset’s cash flows, but assumes an obligation to pass on the cash flows from the underlying assets without material delay;
· cannot sell or pledge the asset; and has no obligation to make payments, unless it collects equivalent amounts from the asset.
Example 2 – Credit enhancements
Entity H sells C10,000 of receivables to a consolidated special purpose entity (SPE) for an upfront cash payment of C9,000 and a deferred payment of C1,000. The SPE issues notes of C9,000 to investors. Entity H will only receive the deferred payment of C1,000 if sufficient cash flows from the receivables remain after paying amounts due to investors. This provides credit enhancement to the noteholders in the form of over-collateralisation. Therefore, entity H suffers the first loss on the transferred assets up to a specified amount.
A transaction that provides credit enhancement via overcollateralisation might result in the entity meeting the pass-through requirements, provided that it does not fail these requirements due to other features in the arrangement.
Example 3 – Loan sub-participations
Bank I originates a large loan for a corporate client. Bank I enters an agreement with other banks. Bank I will receive an upfront cash payment. Bank I will also pass on a percentage of all payments of principal and interest collected on the original loan as soon as they are received to the participating banks. The arrangement is non-recourse, so bank I has no obligation to pay the other banks unless it collects equivalent amounts from the corporate loan. Bank I also cannot sell or pledge the loan. The transaction meets the requirements for a pass-through arrangement, because bank I:
· retains the contractual rights to receive the financial asset’s cash flows, but assumes an obligation to pass on the cash flows from the underlying assets without material delay;
· cannot sell or pledge the asset; and has no obligation to make payments, unless it collects equivalent amounts from the asset.
Example 4 – Pre-funded liquidity reserve
In a securitisation transaction, the SPE (a consolidated subsidiary of the transferor) is required to maintain a liquidity reserve to enable timely payments to be made to noteholders in the event of delayed receipts from the original assets. The transferor (entity A) has pre-funded this reserve by contributing cash or other assets to the SPE when establishing the SPE. If used, the reserve can be recovered only via the retention of future cash flows from the transferred assets.
By establishing a pre-funded liquidity reserve, entity A now has an obligation to pay amounts to eventual recipients that were not collected from the original asset. The transaction does not meet the pass-through requirement. The amounts paid do not represent allowable short-term advances with a full right of recovery. In this instance, the amounts might be outstanding for some time, and there is no right of recovery in the event of insufficient cash flows from the original asset.
The transaction would also fail the pass-through requirements if entity A had provided a firm commitment to advance cash to the SPE when required (rather than pre-funding the reserve), which can be recovered only via retention of future cash flows from the transferred assets. In this case, entity A can be obliged to pay amounts to eventual recipients that were not collected from the original asset, and those amounts are not short-term advances with a full right of recovery.
A liquidity reserve in another SPE is not pre-funded or committed to by entity A. Instead, it is created out of ‘excess’ cash flows collected from the transferred assets over and above those required to pay the eventual recipients. It is contractually specified which cash flows are considered to be ‘excess’ cash flows. When the notes issued by the SPE are fully repaid at the end of the arrangement, entity A is entitled to the remaining balance of the reserve fund. Such a transaction might meet the pass-through requirements. This is because entity A is not paying the eventual recipients any amounts other than those collected from the original asset. Any amounts due to entity A (transferor) that are held in this reserve fund are not ‘collected on behalf of eventual recipients’, and so they cannot be subject to ‘material delay’. However, if, at the end of the agreement, the remaining balance aggregated in the reserve fund (or parts thereof) is distributed to the investors, as eventual recipients, the pass-through requirements would typically not be met, because there would generally be a ‘material delay’ between collection of cash flows from the underlying receivables and pass-through of those amounts to the eventual recipients. In other words, if the investors are the eventual recipients who ultimately receive cash flows collected from the transferred assets, and these cash flows are remitted after a material delay, the pass-through requirements would not be met. Even if the pass-through requirements are met, the risks and rewards analysis should be applied to the transferred financial asset in its entirety, as there is not a transfer of a fully proportionate share of the cash flows; the transferor retains the most residual interest in cash flows from the asset in this arrangement, which affects the risks and rewards analysis.
Example 5 – Revolving structure
An entity sets up a programme to sell specified short-term receivables (such as trade receivables or credit card receivables) originated over five years to a consolidated SPE. The SPE issues long-term notes to investors. Because cash flows are collected on the receivables, those amounts are used by the SPE to purchase new receivables from the entity. At the end of five years, collections from the receivables are used to repay the principal of the long-term notes rather than being invested in new receivables.
Such an arrangement will fail the pass-through test, because the arrangement involves a material delay before the original collection of cash is remitted to the eventual recipient (that is, the note holder). The nature of the new assets typically acquired means that most revolving arrangements involve reinvestment in assets that would not qualify as cash or cash equivalents.
Original assets
The pass-through criteria refer to the cash flows from the ‘original asset’. An issue that arises in practice is determining what can be included in the ‘original asset’. For example, it is not uncommon for an entity that originates loans and receivables to enter into contracts with third parties to mitigate some of the risks of the underlying assets, such as credit insurance, or interest rate swaps. If those loans/receivables are later transferred together with the third-party contracts, to a buyer, the question arises as to what should be regarded as the ‘original asset’.
Entity A (the transferor) sells loan assets to a consolidated SPE. The SPE issues notes to investors that are secured on those assets. Entity A then enters into interest rate swaps with the SPE to mitigate some of the risk on the assets for the noteholders. Cash flows to the noteholders that come from the transferor in relation to the swaps are not considered to be cash flows from the original asset. Therefore the arrangement does not meet the requirements of IAS 39/ IFRS 9.
The situation would have been different if entity A had entered into derivatives or guarantees with a third party to mitigate the risks relating to the loans. Entity A then transfers the loans and the related third-party contracts to a consolidated SPE. The SPE issues notes to investors that are secured on those loans. In such a case, our view is that the ‘original asset’ can be interpreted to mean:
· all related contracts, including insurance contracts, guarantees and derivatives (for example, purchased options and swaps) transferred with the loans/receivables in a single transaction that share and mitigate some of the risks on the loans, because those are the cash flows that will be paid to eventual recipients; under this view, the related contracts would still meet the requirements of the standard; or
· only the transferred loans/receivables themselves, in which case the arrangement would not meet the requirements of the standard.
An entity should choose one of these two approaches as its accounting policy and apply it consistently. When performing a risks and rewards analysis, the net cash flows of the transferred asset should be determined consistently with the policy chosen for determining the original asset. For example, an entity elects to apply a policy that the original asset is a combination of the loan portfolio and related derivatives. The post-transfer cash flows will be the seller’s residual cash flows, taking into account all the payments to and from the recipients (such as noteholders and derivative counterparties).
Cash flows from transferred assets received in different forms
Cash flows from the transferred assets might not be paid to the eventual recipients in exactly the same form.
Example 1 – Pass through of cash in a different currency
Entity A holds bonds denominated in euro. Entity A retains the contractual rights to receive the cash flows from the bonds, but it assumes a contractual obligation to pay those cash flows to overseas investors. The terms of the arrangement require entity A to convert the euro receipts from the bonds to USD, using the market spot rate at the date of conversion and to remit the USD equivalent of the euro cash flows to the investors without material delay.
The conversion of cash flows at spot rate does not preclude the transfer from meeting the pass-through requirements, because the entity has no obligation to pay amounts to the investors unless it collects equivalent amounts from the original asset. In this case, the equivalent amount is the euro equivalent of the USD amount paid to investors, which was received from the original asset (the euro bonds). The entity also has an obligation to remit any cash flows that it collects on behalf of the eventual recipients without material delay. The conversion of those cash flows from euro to USD, using the spot rate at the date of conversion does not impact this obligation.
Example 2 – Pass-through test and net settlement
Entity B holds floating-rate bonds. Entity B retains the contractual rights to receive the cash flows from the bonds, but it assumes a contractual obligation to pay those cash flows to an investor without material delay. At the same time as it transfers the rights to the floating-rate cash flows, entity B enters into a separate interest rate swap with the investor to receive a floating interest rate and pay a fixed interest rate. The notional amount of the swap is equal to the principal amount of the transferred bond. The swap is not part of the ‘original asset’ for the purpose of applying the de-recognition requirements, and the payments on the swap are not conditional on payments being made on the bond. However, the cash flows from the bonds and the interest rate swap will be settled net. If the bond requires a payment from entity B to the investor of C100, while the interest rate swap requires a payment from the investor to entity B of C5, there will be a single, net cash flow of C95 from entity B to the investor.
The net settlement does not preclude the transfer of the bond, because the entity has no obligation to pay amounts in respect of the bond to the eventual recipients, unless it collects equivalent amounts from the original asset. The interest rate swap might give rise to additional cash flows, but these are independent of the original asset, since they are not conditional on payments being made on the transferred asset. On this basis, derecognition is possible. The entity also has an obligation to remit all cash flows that it collects from the bonds without material delay. The fact that the settlement of this obligation might be net of cash flows from another independent financial instrument (the interest rate swap) does not preclude de-recognition. The cash flows deducted are not conditional on payments being made on the transferred asset. There would still be a net cash flow between the investor and entity B under the swap if cash flows were not received from the bonds.
The second condition is that the entity is prohibited by the transfer contract’s terms from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows.
Prohibition from selling or pledging the asset
The second condition, regarding the transferor’s ability to sell or pledge the financial assets, highlights the fact that the transferor does not control access to the future economic benefits associated with the transferred cash flows, and, so it might not have an asset.
The third condition is that the entity has an obligation to remit any cash flows that it collects on behalf of the eventual recipients without material delay. The transferor is not entitled to reinvest such cash flows, except in cash or cash equivalents (as defined in IAS 7) during the short settlement period from the collection date to the date of required remittance to the eventual recipients. Any interest earned on such investments must be passed to the eventual recipients.
Obligation to remit cash flows ‘without material delay’
The third condition ensures that the transferor does not have use of, or benefit from, the cash that it collects on the transferee’s behalf. The transferor is also required to remit the cash collected ‘without material delay’. This condition helps to ensure that the transferor has no asset. Immaterial delay is permitted for practical reasons. ‘Without material delay’ is not defined in the standard, so judgement is required in making this assessment. The underlying facts and circumstances need to be reviewed, to assess whether the time interval between collection of the cash flows and their remittance to eventual recipients is reasonable, in relation to the timing of payments on the underlying assets and market practices. For example, in some pass-through arrangements (such as securitisation of a portfolio of a large number of receivables), it is often not practical for the entity to transfer the relatively small amounts of cash collected from individual accounts as and when they arise. Instead, for administrative convenience, the contractual arrangement might provide for their remittance to be made in bulk, on a weekly, monthly or quarterly basis. In such situations, a remittance period of three months or less is generally acceptable, because, in most securitisations, interest is paid on a quarterly basis. One example of this is credit card balances, where customers often pay off the outstanding balance on a range of days each month.
The third condition also restricts any investment made for the transferee’s benefit to cash or cash equivalents as defined in IAS 7. Therefore, the transferor is not allowed to invest the funds in other high-yielding medium-term investments for the benefit of the transferee, or to utilise the funds in generating further assets for securitisations. The transferor is also not permitted to retain any interest from such short-term highly liquid investments. All interest received (but no more) must be remitted to the transferee as it arises. In practice, the funds are often paid into a trustee bank account for the transferee’s benefit.
Once an entity has established that it has transferred a financial asset, either by transferring the contractual rights to receive the cash flows or under a qualifying pass-through arrangement, it carries out the risks and rewards test. This test requires the entity to evaluate whether it has:
Determine whether substantially all the risks and rewards of ownership have been transferred
The entity must de-recognise the financial asset if it transfers substantially all the risks and rewards of ownership of the asset. It might also have to recognise separately as assets and liabilities any rights and obligations created or retained in the transfer.
Transfer substantially all the risks and rewards
Examples of transactions that transfer substantially all the risks and rewards of ownership include:
· An unconditional sale of a financial asset. This is the most obvious example.
· A sale of a financial asset, together with an option to repurchase the financial asset at its fair value at the time of repurchase. The entity is no longer exposed to any value risk (potential for gain and exposure to loss) on the transferred asset. This is borne by the buyer. The ability for the seller to buy the asset back at its fair value at the date of repurchase is economically no different from buying a new asset.
· A sale of a financial asset, together with a put or call option that is deeply out-of-the-money (that is, an option that is so far out-of-themoney that it is highly unlikely to go into-the-money before expiry). In this situation, the seller has no substantial risks and rewards, because there is no real possibility that the call or put option will be exercised. Because the option has little or no value, such a sale has economically little difference from an unconditional sale.
· The sale of a fully proportionate share of the cash flows from a larger financial asset in an arrangement that meets the pass-through conditions.
An entity that has transferred substantially all the risks and rewards of ownership of the transferred asset as a result of the transfer, does not recognise the transferred asset again in a future period. However, it would recognise the transferred asset if it re-acquires it in a new transaction.
Risks and rewards to include in consideration The risks and rewards to be considered include interest rate risk, credit risk, foreign exchange risk, equity price risk, late payment risk and prepayment risk. The applicable risks will depend on the particular asset that is being considered for de-recognition.
Examples of the types of risk which might apply are:
· For short-term trade receivables, credit risk and late payment risk. Foreign currency risk might also be applicable if the receivables have been transacted in a foreign currency.
· For mortgages, interest rate risk, credit risk and, in the case of fixedrate mortgages, prepayment risk.
Impact of certain conditions on risks and rewards
Sometimes, transfers of financial assets are made subject to certain conditions. These conditions should be assessed to determine whether they should be taken into account for a risks and rewards analysis.
Example 1 – Warranties and credit notes
In our view, warranties to enable customers to return faulty goods and credit notes given for volume discount should not be taken into account for the risks and rewards analysis. This is because warranties relate to the asset’s condition at the date of sale and to whether a valid receivable exists, rather than to risks and benefits in relation to its future performance. Similarly, contractual credit notes relate to the overall contractual relationship between the seller and its customer, and not to the contract that is the receivable.
Example 2 – Two-party offset arrangements
Two-party offset arrangements are also not factored into the risks and rewards analysis. An example of such an arrangement is where entities Q and R owe each other amounts and these amounts are subject to a legal right of offset. Entity R sells its receivables due from entity Q to entity S. Entity R agrees with entity S that, if entity Q exercises its right of offset on a transferred receivable, entity R will make an equivalent payment to entity S. Therefore, the payment made by the seller (entity R) to the buyer (entity S), if the right of offset is exercised, merely transfers to the buyer the value that the seller obtained when its receivable from the debtor was extinguished.
Example 3 – Option or commitment to repurchase a transferred asset on a change in circumstances
An entity has sold receivables to a factor. Within the terms of the sale agreement, if there is a change in the tax law/regulation, the entity has the option (or is committed) to repurchase the transferred assets from the factor at par. Risks and rewards are measured as an entity’s exposure to variability in cash flows from the transferred asset. If the entity might (or might have to) repurchase the transferred asset for an amount which is not its fair value, it has retained some of the risks and rewards. The extent of risks and rewards retained depends on how likely the entity is to repurchase the receivables.
The transfer of substantially all the risks and rewards of ownership will generally be apparent from the terms and conditions of the transfer. If the transfer is not obvious, the entity needs to compare its exposure to the variability in the present value of the transferred asset’s future net cash flows before and after the transfer. The net cash flows of the transferred assets should be determined on a basis consistent with the ‘original asset’. The computation and comparison should be made using an appropriate current market interest rate as the discount rate. All reasonably possible variability in net cash flows (as to amount and timing) should be considered. The amounts and timing of cash flows should be probability weighted.
The contractual arrangement might result in the entity’s exposure to variability in net cash flows no longer being significant in relation to the total variability in the present value of the future net cash flows from the financial asset. The entity is regarded as having transferred substantially all the financial asset’s risks and rewards of ownership. Variability is a relative and not an absolute test. Therefore, de-recognition is not achieved solely if the entity’s remaining exposure to an asset’s risks and rewards is small in absolute terms.
No guidance is provided to establish what ‘significant’ variability is when comparing the difference between the present value of the cash flows from the financial asset before the transfer with the present value of the cash flows after the transfer. Therefore, judgement is needed. A numerical computation is not necessarily required, because it might be obvious whether the entity has transferred substantially all the risks and rewards of ownership.
Variability in the amounts and timing of cash flows
In some cases, it is not obvious whether the difference between the present value of the cash flows from a financial asset before the transfer and the present value of the cash flows after the transfer is significant. Therefore, a computation will be required. There is limited guidance in the standard as to how to perform such a computation. This could be done in a number of ways.
An entity sells a portfolio of short term 30 day receivables to a third party. The receivables have a nominal value of C1 billion. The entity guarantees first losses on the portfolio, up to 1.25% of the loan volume. The average loss on similar receivables over the last 10 years amounts to 2%.
The expected losses are C20 million and the entity has guaranteed C12.5 million. It might appear that, because the entity has guaranteed 62.5% of all of the expected losses, it has retained substantially all the risks and rewards of ownership. This is not the case, because, the calculation cannot be done in this manner. The test looks to who absorbs variability in the asset’s cash flows, rather than who has most of the expected losses. By giving a guarantee, the entity has effectively retained a subordinated interest in the receivables. If the retained subordinated interest absorbs all of the likely variability in net cash flows, the entity would retain the risks and rewards of ownership and continue to recognise the receivables in their entirety. However, this is not the case in this example. In order to perform a risk and rewards analysis, it is necessary to determine the variability in the amounts and timing of the cash flows, both before and after the transfer, on a present value basis. One way to determine this is outlined below:
· Model different scenarios of cash flows from the C1 billion receivables portfolio that reflect the variability in the amounts and timing of cash flows before the transfer.
· For each scenario, the present value of the cash flows is calculated by using an appropriate current market interest rate.
· Probabilities are assigned to each scenario, considering all reasonably possible variability in net cash flows, with greater probability weighting given to those outcomes that are more likely to occur.
· An expected variance is then calculated that reflects the cash flows’ total variability in the amounts and timing.
The steps are then repeated for cash flows that remain after the transfer.
Finally, the expected variance after the transfer is compared with the variance before the transfer, to determine whether there has been a significant change in the amounts and timing of cash flows as a result of the transfer. If the change is not significant, it can be concluded that there has been no substantial transfer of the risks and rewards of ownership. If the change is significant, it can be concluded that the risks and rewards of ownership have been substantially transferred.
An illustration of the modelling discussed above is shown below. For illustrative purposes, only six scenarios are included in this example. In practice, more scenarios might be required in order to adequately model the variability in net cash flows of the asset.
Pre-transfer
Scenarios PV of future cash flows Probability % Expected PV Variability in PV Probability weighted Expected variability 1 2 3 = 1*2 4 = 1- ∑3 5=2*4 Low loss 990,000 15.00 148,500 11,050 1,658 1,658 Normal loss and few prepayments 985,000 20.00 197,000 6,050 1,210 1,210 Normal loss 980,000 35.00 343,000 1,050 368 368 Normal loss and many prepayments 970,000 25.00 242,500 -8,950 -2,238 2,238 High loss 960,000 4.50 43,200 -18,950 -853 853 Very high loss 950,000 0.5 4,750 -28,950 -145 14 5
100.00 978,950 – 38,700 0 6,472 Post-transfer
Scenarios PV of future cash flows Probability % Expected PV Variability in PV Probability weighted Expected variability 1 2 3 = 1*2 4 = 1- ∑3 5=2*4 Low loss 10,000 15.00 1,500 -2,125 -319 319 Normal loss and few prepayments 12,500 20.00 2,500 375 75 75 Normal loss 12,500 35.00 4,375 375 131 131 Normal loss and many prepayments 12,500 25.00 3,125 375 94 94 High loss 12,500 4.50 563 375 17 17 Very high loss 12,500 0.5 63 375 2 2 100.00 12,125 250 0 638 The relative variability retained after the transfer is 638/6,472 = 9.86%. This implies that the entity has transferred substantially all of the risks and rewards of ownership of the receivables.
It should be noted that the cash flows’ present value with their associated probabilities, constitutes a discrete random variable. For this variable, it is possible to derive an absolute value for the variability. A better measure would be to calculate the standard deviation. In this example, that would also produce the same conclusion. However, in practice, the calculation might not be so simple and specialist advice should be taken.
Determine whether substantially all the risks and rewards of ownership have been retained
If the entity retains substantially all the risks and rewards of ownership of the asset, it continues to recognise the asset.
Transactions where risks and rewards are retained
Examples of transactions where substantially all the risks and rewards of ownership has been retained are:
· A sale and repurchase transaction, where the repurchase price is a fixed price or the sale price plus a lender’s return (for example, a repo or securities lending agreement).
· A sale of a financial asset, together with a total return swap that transfers the market risk exposure through the swap back to the entity.
· A sale of a financial asset, together with a deep in-the-money put or call option (that is, an option that is so far in-the-money that it is highly likely to be exercised before expiry).
· A sale of short-term receivables in which the entity guarantees to compensate the transferee for all credit losses which are likely to occur.
The comparison of the variability of the transferred asset’s cash flows before and after the transfer might show that the entity’s exposure to the variability does not change significantly as a result of the transfer. The entity is regarded as having retained substantially all the risks and rewards of the asset’s ownership, and it continues to recognise the asset.
Determining a transfer of risks and rewards in a factoring arrangement with recourse
Entity A transfers a portfolio of trade receivables to a factor. The factor assumes the default risk of the transferred receivables. Entity A retains the late payment risk by paying interest on overdue amounts to the factor, based on LIBOR plus a margin. The trade receivables transferred have a history of no defaults and no late payment since the start of the business relationship between entity A and the customers.
The risks and rewards test should compare on a relative, and not an absolute, basis: entity A’s retained risks and rewards after the transfer (this is the variability due to late payment risk); and the total risks and rewards associated with the financial asset before the transfer (this should take into account both the risk of default and the risk of late payment).
The lack of observed defaults and late payments does not justify an assumption that there are no risks attached to the receivables transferred to the factor. In the absence of any observable data, the risks and rewards test should be performed by looking at both qualitative and quantitative factors.
The objective is to gain insight into the economics of the default and the late payment risks, so as to be able to assess their relative significance. Qualitative questions to be addressed could include:
· How are late payment and default risk managed by entity A? The amount of resources that entity A devotes to managing a risk might indicate the relative importance that it attaches to that risk.
· If the factor is, in general, unwilling to assume late payment risk, why is this?
· If the factor is willing to assume the late payment risk as well as the default risk that it has actually assumed, what price would/does it charge?
Quantitative aspects include using index information of peers or industries to approximate the default risk and the late payment risk inherent in the portfolio of receivables transferred to the factor.
If this information does not make the result of the risks and rewards analysis clear, it might be necessary to build a model that encompasses all of the data and information gathered (that is, a numerical computation of risks and rewards). The modelling of risks and rewards is complex and will be subject to simplifications and assumptions.
To the extent that the qualitative factors indicate that a significant risk has been retained, the entity should be able to demonstrate objectively that the late payment risk is not significant in order to achieve de-recognition Such a quantitative analysis should use data that is relevant to the receivables being factored.
Determine whether control of the asset has been retained
An entity (transferor) that has retained some risks and rewards, but not substantially all of them, is in a middle ground in which the risks and rewards analysis does not provide a clear answer. The transferor then has to determine whether it has retained control of the asset:
Control is based on whether the transferee has the practical ability to sell the transferred asset. Control, in this context, does not have the same meaning as in IFRS 10.
The ability to sell a transferred asset looks to what the transferee, and not the transferor, can do with the asset. This concept of control tries to identify whether the transferor continues to be exposed to the variability in the cash flows of the particular asset that was the subject of the transfer. This is different from having risks of a general nature, similar to a derivative. If the transferee has the practical ability to sell the transferred asset, it has control over the asset and the transferor has lost control. If the transferee does not have the practical ability to sell the transferred asset, the transferor has retained control of the transferred asset.
Practical ability to sell the transferred asset
The transferee has the ‘practical ability’ to sell the transferred asset if:
These conditions should be evaluated by considering what the transferee is able to do in practice, and not what contractual rights it has with respect to the transferred asset (or, indeed, what contractual prohibition exists).
The transferee might have a contractual right to dispose of the transferred asset. That right will have little practical effect if there is no market for the transferred asset.
Indicators that a market exists
Judgment might be required in determining whether a market exists. Set out below are indicators to consider in making this assessment:
Factor Indicators that a market exists Number of market participants A reasonable number of potential purchasers exists. A single potential purchaser rarely indicates the existence of a market. The existence of other potential sellers might also be an indicator of a market, particularly if it gives rise to more potential purchasers, but it is not necessarily conclusive in determining the existence of a market that gives them the practical ability to sell their asset. Frequency of transactions Transactions occur with reasonable frequency in order for a seller to have an expectation of being able to sell its asset in a market. Transactions might involve either identical assets or similar assets (see below). Similarity of assets A market does not require recent past transactions in an identical asset, if there have been transactions in similar assets and those past transactions indicate the ability to sell the asset. For instance, transactions in certain securities might indicate the existence of a market for another similar security, or transactions in certain trade receivables might indicate the existence of a market for other trade receivables from the same issuer. Available pricing information Pricing information is available to participants in the market. This might take various forms (for example, indicative price quotes providing information to potential sellers, or reports of recent actual transaction prices).
It might also be necessary to determine if the market is an active market where the transferor has an option to repurchase the asset so the transferee might be required to return it. The transferee will have the practical ability to sell the transferred asset if there is an active market in that asset. The transferee could repurchase the transferred asset in the market if it needs to return the asset to the entity.
The transferee should also be able to exercise its ability to transfer the asset independently of the actions of others. The transferor should not impose additional restrictions or ‘strings’ to the transfer.
Sale of loan portfolio with credit default guarantee
It is important to establish if an active market exists for the identical asset. The fact that the transferee might be unlikely to sell the transferred asset is of no relevance, provided that it has the practical ability to do so. If the transferor has imposed obligations on the transferee concerning the servicing of a loan asset, the transferee would need to attach a similar provision to any transfer that it makes to a third party. Such ‘additional restrictions’ or ‘strings’ impede the asset’s free transfer and fail the ‘practical ability to sell’ test. Entity O sells a portfolio of loans to bank N for cash. The loans have an average historical loss ratio of 5%.
Entity O guarantees credit default losses on the transferred assets of up to 4% as part of the arrangement. The terms of the guarantee specify that the holder of the guarantee can only claim under the guarantee if it holds the guaranteed loans. The credit default guarantee means that control has not been transferred. Bank N would lose the value of the credit default protection if it sold the transferred asset without also selling the credit default guarantee to the new buyer. In practice, bank N would only sell the transferred asset if it also sold the credit default protection to the buyer. However, giving such credit default protection is the insertion of an additional feature and, therefore, fails the control test.
If the transferor writes a put option or provides a guarantee of the original asset the transfer will also often fail the control test. The transferee has effectively obtained two assets. The first is the original asset that is the subject of the transfer. The second is the put option or the guarantee. The transferee will only be able to realise the asset’s value by selling a similar guarantee or put option with the assets, in the absence of an active market. If the put option or guarantee is valuable to the transferee, the transferee would not, in practice, sell the transferred asset to a third party without attaching a similar option or guarantee. The ‘practical ability to sell’ test fails because the transferee is constrained from selling the asset without attaching additional restrictions. Control of the transferred asset is retained by the transferor.
Practical ability to sell transferred assets
If the transferee has the practical ability to sell the transferred asset, the transferee has control over the asset. The transferor has lost control and derecognises the asset. If the transferee does not have the practical ability to sell the transferred asset, the transferor has retained control of the transferred asset. The transferor continues to recognise the asset to the extent of its continuing involvement.
The ‘control’ concept is important, because it helps to determine how the transferor’s remaining interest in the asset will be presented. If the transferor has retained control, it still has an interest in the specific assets that have been transferred. Therefore, it should continue to show that interest on the balance sheet, gross of any related liability. If control has been lost, the transferor still shows its remaining economic interest on the balance sheet, but presented net. This recognises that the transferor’s interest is a net exposure (that is, more akin to a derivative), rather than an interest directly related to the specific assets that have been transferred.
Continuing involvement in transferred asset
The continuing involvement approach applies if:
The entity continues to recognise part of the asset under the continuing involvement approach, and that part represents the extent of its continuing exposure to the risks and rewards of the financial asset.
Continuing involvement
The continuing involvement includes both obligations to support the risks arising from the asset’s cash flows (for example, if a guarantee has been provided) and the right to receive benefits from these cash flows. A related liability is recognised if continuing involvement includes obligations, such as guarantees, as well as part of the original asset.
Warranties, contractual credit notes and two-party offset arrangements are not taken into account in measuring an entity’s continuing involvement. This is because:
· Such arrangements do not prevent a transfer of contractual rights to receive cash flows from an asset. Warranties relate to the asset’s condition at the date of sale and to whether a valid receivable exists (business risk of the underlying transaction), rather than to risks and benefits in relation to its future performance (financial risk associated with the asset).
· Contractual credit notes relate to the overall contractual relationship between the seller and its customer, rather than the specific contract which creates the receivable.
· Two-party offset arrangements merely transfer to the transferee the value that the transferor obtained when its receivable from the debtor was extinguished.
On the other hand, options or commitments to repurchase the transferred assets on a change in circumstances should be taken into account in measuring the entity’s continuing involvement. An example of a change in circumstance is a change in tax law or regulation.
An entity has sold receivables to a factor. Within the terms of the sale agreement, if there is a change in the tax law or regulation, the entity has the option (or commitment) to repurchase the transferred assets from the factor at par. Such right (or commitment) is related specifically to a particular receivable. Therefore, it should be taken into account in measuring the entity’s continuing involvement. If the option (or commitment) is to repurchase any receivable, the continuing involvement asset would be the entire group of receivables. As such, no de-recognition would be achieved.
Accounting by transferee
Transferees are required to follow IAS 39/ IFRS 9’s recognition principles. The accounting treatment between the transferor and the transferee is expected to be symmetrical. Therefore, to the extent that a transfer of a financial asset does not qualify for de-recognition, the transferee does not recognise the transferred asset as its asset. The transferee derecognises the cash or other consideration paid, and it recognises a receivable from the transferor. If the transferor has both a right and an obligation to reacquire control of the entire transferred asset for a fixed amount (such as under a repurchase agreement), the transferee could classify its receivable as a ‘loan and receivable’ under IAS 39 or measure it at amortised cost under IFRS 9 if it meets the requirements for such measurement. If a transfer of a financial asset qualifies for de-recognition, the transferor will treat it as a sale and the transferee will treat it as a purchase.
Repurchase and stock lending agreements
The motivation to enter into a securities lending transaction is different from a repurchase agreement. The transactions might also differ in form and risk protection but they are similar in substance. IAS 39/IFRS 9, therefore, does not distinguish between the two types in determining whether the transferred asset qualifies for de-recognition.
Background to repurchase and stock lending agreements
Repurchase agreements, commonly referred to as ‘repos’, are transactions where there is a legal sale of a financial asset with a simultaneous agreement to repurchase it at a specified price at a fixed future date. In a typical repurchase agreement, an entity might sell a security (such as a government bond) to a third party in return for a cash consideration that is then reinvested in other assets that earn a return. At the specified date, the transferor repurchases that security. Financial institutions and other entities normally enter into these agreements because they provide liquidity and the opportunity to earn excess returns on the collateral. The main features of such agreements will usually be:
· The sale price – this could be the market value at the date of sale or another agreed price.
· The repurchase price – this could be fixed at the outset, it could vary with the period for which the asset is held by the buyer, or it could be the market price at the time of repurchase.
· The nature of the repurchase agreement – this could be an unconditional commitment for both parties, a call option exercisable by the seller, a put option exercisable by the buyer or a combination of put and call options.
· Other provisions – these might include, amongst others, the term of the agreement (overnight, short-term or longer); the buyer’s ability to return a similar but not identical security to that which was sold; and the buyer’s ability to sell the security to a third party, the seller retaining access to any increase in the asset’s value (subject to the buyer receiving a lender’s return) from a future sale to a third party, and the seller providing any protection against loss through the operation of guarantees.
Background to stock lending agreements
Stock lending transactions are initiated by broker-dealers and other financial institutions to cover a short sale or a customer’s failure to deliver securities sold. These are also sometimes referred to as securities lending transactions. In a typical agreement, the transferor/lender transfers a security to the transferee/borrower for a short period of time. The borrower is generally required to provide ‘collateral’ to the lender. Collateral is commonly cash, but it is sometimes other securities or a standby letter of credit, with a value slightly higher than the value of the security borrowed. If the collateral is cash, the lender earns a return and, if it is other than cash, the lender receives a fee. At a specified date, the borrower returns the security to the lender.
There is typically a legal sale of the underlying assets in repurchase and stock lending agreements. The transferor has transferred the contractual rights to receive the cash flows of the financial assets and there is a transfer that meets the IAS 39/IFRS 9 criteria.
A repurchase agreement might contain a provision that allows the transferor to settle net in cash. The transferor settles the transaction net in cash by paying or receiving the difference between the fair value of the asset at the date of repurchase and the fixed repurchase price, instead of taking physical delivery of the asset. The fact that the transferor is able to settle the transaction net in cash does not automatically mean that the transferor has lost control of the asset. The transferor must still pass the ‘risks and rewards’ test, as well as the control test, before the transferor can de-recognise the transferred asset.
Sale and repurchase transaction (gross settled)
An entity purchases C10 million, 10%, five-year government bonds on 1 January 20X4, with semi-annual interest payable on 30 June and 31 December, for C10.8 million that results in a premium of C800,000. The entity measures the bonds at amortised cost. The amortisation of the bonds to maturity, using the effective interest method is shown below:
Cash received Interest income @ 4.013% Carrying amount 1 Jan 20X4 10,800,000 1 Jul 20X4 500,000 433,408 10,733,408 1 Jan 20X5 500,000 430,735 10,664,143 1 Jul 20X5 500,000 427,956 10,592,099 1 Jan 20X6 500,000 425,064 10,517,163 1 Jul 20X6 500,000 422,057 10,439,220 1 Jan 20X7 500,000 418,929 10,358,149 1 Jul 20X7 500,000 415,676 10,273,825 1 Jan 20X8 500,000 412,292 10,186,117 1 Jul 20X8 500,000 408,772 10,094,889 31 Dec 20X8 500,000 405,111 10,000,000 5,000,000 4,200,000 On 1 July 20X5, the entity sells the bond at its fair value of C10.6 million to a third party, with an agreement to repurchase the bond on 1 July 20X6 for C10.65 million.
Because the repurchase price is fixed at the outset, the entity is precluded from de-recognising the bond. The transferee will be entitled to receive the interest due on 1 January 20X6 and 1 July 20X6 (that is, C1 million), together with the difference between the repurchase price and sale price of C50,000. This represents a lender’s return of 9.8943% per annum on the sale price. Therefore, the entity will continue to recognise the bond and the interest on it, as if it still held the bonds.
It should be noted that, although the repurchase agreement meets the definition of a derivative (it can be viewed as a forward contract), it is not separately recognised as a derivative and measured at fair value. To do this would result in double counting of the same rights. Therefore, in this situation, the forward contract to repurchase the financial asset at a fixed price is not recorded as an asset.
The entity will also record a liability of C10.6 million for the proceeds received. This liability accretes to the amount payable on repurchase of C10.65 million at 1 July 20X6, using the effective interest method. The entity will continue to recognise a notional interest income in the periods to 1 January 20X6 and 1 July 20X6, and it will also account for an equal amount of notional interest paid to the third party. On 1 July 20X6 following repurchase of the bond by the entity, the liability of C10.65 million will be eliminated, as shown below:
Liability carrying value Liability at 1 July 20X5 10,600,000 Interest payable for the half year to 31 December 20X5 @ 9.8943% 524,397 Notional cash paid to third party on 31 December 20X5* (500,000) Balance at 31 December 20X5 10,624,397 Interest payable for the half year to 30 June 20X6 @ 9.8943% 525,603 Notional cash paid to third party on 30 June 20X6* (500,000) Balance at 30 June 20X6 10,650,000 Liability repaid on 1 July 20X6 at repurchase price (10,650,000) * third party will receive interest directly from the bond as legal owner. The transferee might be able to pledge or sell the bond during its period of ownership. In that situation, the transferor should reclassify the bond on its balance sheet as a loaned asset or repurchase receivable.
Sale and repurchase transaction (net settled in cash) under IAS 39
On 1 July 20X5, an entity sells a bond at its fair value of C10.6 million to a third party, with an agreement to repurchase the bond on 1 July 20X6 for C10.65 million. The amortised cost of the bond at the sale date is C10,592,099. The repurchase contract is to be settled net in cash (that is, the entity will not physically receive the bond back at the settlement date). The fair value of the asset at the settlement date amounts to C10.655 million. This means that the entity will receive an additional C5,000 from the third party.
The fact that the forward repurchase agreement requires net settlement does not automatically lead to de-recognition. In this example, the entity continues to recognise the asset at the net settlement price. The net settlement price is the difference between the fair value of the bond and the fixed price of C10.65 million in the contract. Therefore, the entity is still exposed to the risks and rewards of the bond for the term of the contract. Because the entity will not physically receive the bond back, the bond will be de-recognised following receipt of the additional consideration of C5,000 at the settlement date.
Therefore, it would not be appropriate to continue to classify the bond as held-to-maturity at amortised cost. Instead, the entity would need to reclassify the bond as an available-for-sale financial asset at fair value at the sale date of 1 July 20X5. Where an entity, during the current financial year, has sold or reclassified more than an insignificant amount of held-to-maturity investments before maturity (that is, more than insignificant in relation to the total amount of held-tomaturity investments), it is prohibited from classifying any financial asset as held-to-maturity for a period of two years after the occurrence of this event. The reclassification results in a gain to other comprehensive income as shown below:
Fair value of bond at 1 July 20X5 10,600,000 Amortised cost of bond at 1 July 20X5 10,592,099 Gain transferred to other comprehensive income following reclassification 7,901 Therefore, the entity will record the bond at its fair value of C10.6 million and a corresponding liability of C10.6 million. The bond will be remeasured to fair value each reporting period (e.g. if there is a reporting period ending 31 December 20X5). The liability accretes to the repurchase price of C10.65 million, using the effective interest method.
At the settlement date of 1 July 20X6, immediately before de-recognition the bond will be fair valued to C10.655 million and a further gain of C5,000 will be recorded in other comprehensive income. Because the contract will be net settled in cash, the bond is then de-recognised. The cumulative gain in other comprehensive income will be reclassified to profit or loss. The entity will record the following entries:
Dr Cr C C Liability 10,650,000 Bond 10,655,000 Cash settlement 5,000 Other comprehensive income – recycling of cumulative gain (7,901 + 5,000) 12,901 Gain on disposal 12,901 Although a forward repurchase agreement that requires net settlement in cash is economically equivalent to a deferred sale, the entity cannot derecognise the asset, because the risks and rewards of ownership have been retained until settlement.
A repurchase agreement will require the transferor to repurchase the transferred asset at a particular price. The price might be fixed at the outset, or it might be the market price at the time of the repurchase. Derecognition depends on the pricing arrangement. If the financial asset is loaned or sold under an agreement to repurchase at fair value at the date of repurchase, the transferred asset is de-recognised. The transferor has transferred substantially all the risk and rewards of ownership of the transferred asset. If the financial asset is loaned or sold under an agreement to repurchase the asset at a fixed price or at a price that provides a lender’s return on the sale price, the transferred asset is not de-recognised. The transferor retains substantially all the risks and rewards of ownership of the transferred asset.
A repurchase or stock lending agreement might require the transferor to accept assets in return that are substantially the same as those initially transferred. The term ‘substantially the same’ is not defined. It is generally understood to mean that the financial assets returned or repurchased must be identical in form and type and have identical maturities and contractual interest rates. They provide the same rights as the asset transferred. The transferor retains substantially all the risks and rewards of ownership, because there is no economic difference between the asset initially transferred and the asset to be re-acquired.
A repurchase or stock lending agreement might give the transferee the right to substitute a similar asset of equal fair value at the repurchase date. There is no economic difference in substance between returning the original asset or a similar asset of equal fair value. The transferor retains substantially all the risks and rewards of ownership.
An entity that sells a financial asset, and retains only a right of first refusal to repurchase the transferred asset at fair value, de-recognises the asset because it has transferred substantially all the risks and rewards of ownership.
Repurchase not at fair value
A right of first refusal to repurchase the transferred asset might be at a price other than the asset’s fair value at the date of repurchase (for example, a price pre-determined at inception). This scenario is not dealt with in the standard. We consider that the situation is similar to the transferor having a call option.
The option to purchase at a price other than fair value might mean that the entity has neither retained nor transferred substantially all the risks and rewards of ownership and has not retained control. If this is the case the option’s existence might mean that the transferor has a continuing involvement in the asset.
If the asset is readily obtainable in the market, this means that the call option has no practical effect in creating any constraints on the transferee’s practical ability to sell the asset. This is because, if the transferred asset has been sold by the transferee and the transferor exercises the call option, the transferee will be able to fulfil its obligation by purchasing a replacement asset from the market. Therefore, the transferor retains no control over the transferred asset, and de-recognition of the transferred asset is appropriate. The transferor would account for the option as a derivative at fair value, with changes in fair value reflected in profit or loss.
A repurchase or securities lending agreement could give the transferee the right to sell or pledge the transferred asset during the term of the repurchase agreement. If the transferor continues to recognise the asset, it should reclassify the asset on its balance sheet (for example, as a loaned asset or repurchase receivable).
Generally, the transferee’s right to sell or pledge the transferred asset effectively indicates that the transferee has control of the asset. Derecognition is appropriate if some significant risks and rewards are transferred. The right to sell or pledge must have economic substance, without any ‘strings’ attached, for control to pass to the transferee.
A ‘wash sale’ is the repurchase of a financial asset shortly after it has been sold. This is also sometimes referred to as a ‘bed and breakfast’ transaction. The transaction involves contracting to sell the financial asset to a third party with no express contract to buy it back. Subsequent repurchase does not preclude de-recognition provided that the original sale transaction met the de-recognition requirements. Wash sales are viewed as two separate transactions. The time interval between sale and repurchase can be very short, and it is unlikely that the transferor would benefit or suffer from changes in asset values. The transactions are normally undertaken to crystallise a capital gain or capital loss for taxation purposes. Alternatively, they are used to convert unrealised revaluation gains on investments into realised gains, so that they can be used for distribution by way of dividends to shareholders. However, if an agreement to sell a financial asset is entered into concurrently with an agreement to repurchase the same asset at a fixed price, or the sale price plus a lender’s return, the asset is not de-recognised.
The sale price is assumed to be satisfied in cash in the sale and repurchase agreements considered in IAS 39/ IFRS 9. A variant in practice is that the sale consideration is satisfied by the transfer of another security rather than cash. Each transferor will first apply the de-recognition criteria to its own security. This is a risks and rewards approach first followed by the control approach if the risks and rewards approach is found not to be conclusive. Each transferor must then consider if the counter party has met the de-recognition criteria for the asset that the transferor has received. If the counterparty would continue to recognise the asset under IAS 39/ IFRS 9, the asset is not recognised by the entity.
Security given as collateral
Assume that entity A sells security X to entity B subject to a repurchase agreement. The sale consideration is met by entity B transferring security Y. Such a transaction involves two transfers and two transferors, so the requirement relating to the accounting treatment relating to transfers of financial assets will need to be applied twice – to the transfer of security X by entity A, and to the transfer of security Y by entity B.
Linkage of transactions into a derivative
An entity might enter into two or more transactions relating to the same asset at (or about) the same time. The issue arises as to whether these transactions should be accounted for separately, or aggregated and accounted for as a single transaction. Certain linked non-derivative transactions should be aggregated and treated as a derivative where, in substance, the transactions result in a derivative instrument.
Entity A purchases a sovereign bond at fair value from entity B. At the same time, entity A enters into a sale and repurchase agreement (repo) of the bond with entity B. Under the repo, entity A sells the bond back to entity B and agrees to buy it back from entity B on a specified future date at a specified price. The net effect of the two transactions is that no cash or bonds are exchanged between entities’ A and B at inception.
During the term of the transaction, entity A will pay to entity B interest on the notional financing under the repo, and entity B will pay to entity A any interest coupons received on the bond (although these amounts might be rolled into the repurchase price and paid at the end of the repo). On maturity of the repo, entity B will deliver the bond to entity A in return for cash equal to the pre-agreed price.
The cash flows of this transaction are consistent with the cash flows of a total return swap, with physical settlement at the swap’s maturity. If the two interest payments are rolled up and paid at the end of the term of the repo, the cash flows are similar to a forward contract to buy the bond.
The definition of a derivative is met because the value of the transaction moves in response to the change in the fair value of the bond. The initial net investment is small and the transaction will be settled at a future date.
The indicators of when non-derivative transactions should be treated as a derivative are met, because the transactions are entered into at the same time and in contemplation of each other, both relate to the same risk (since they relate to the same bond) and both are with the same counterparty, entity B. There is also no apparent economic need or substantive business purpose for the transactions to be structured separately. The transaction should therefore be accounted for together, as a derivative.
Factoring arrangements
A factoring transaction involves a transferor transferring its rights to some or all of the cash collected from some financial asset (usually receivables) to a third party (the factor) in exchange for a cash payment.
Factoring of receivables is a well-established method of obtaining finance, sales ledger administration services or protection from bad debts. Factoring arrangements can take various forms, but some of the principal features are:
· The cash payment – this can be fixed at the outset, or it can vary according to the actual period for which the receivables remain unpaid (late payment risk). Sometimes, the factor might provide a credit facility that allows the seller to draw up to a fixed percentage of the face value of the receivables transferred.
· The nature of the agreement – this might be a clean sale without recourse (the transferor has no obligations to make good any shortfall on the transferred assets), or it might be more complex with various recourse provisions.
· Other provisions – these might include, amongst others, any representations or warranties provided by the transferor regarding the receivables’ quality/condition at the point of transfer; servicing arrangements (whether the transferor will continue to manage the receivables or management will be taken over by the factor); or any credit protection facility (insurance cover) provided by the factor that might limit or eliminate the extent to which the factor has recourse to the seller.
Example 1 – Factoring without recourse
In a non-recourse factoring arrangement, the transferor does not provide any guarantee about the receivables’ performance. In other words, the transferor assumes no obligations whatsoever to repay any sums received from the factor regardless of the timing or the level of collections from the underlying debts. In that situation, the entity has transferred substantially all the risks and rewards of ownership of the receivables and de-recognises the receivables in their entirety.
Example 2 – Requirement for a transfer
In most factoring arrangements, the factored receivables are assigned to the factor. As a result the transferor has transferred the contractual rights to receive the financial asset’s cash flows and there is a transfer. However, this might not be the case if there are three party offset rights.
Example 3 – Factoring with recourse
In factoring of receivables, the transferor can provide the factor with full or limited recourse. The transferor is obligated, under the terms of the recourse provision, to make payments to the factor. Alternatively, the transferor might be required to repurchase receivables sold under certain circumstances. These recourse provisions might take the form of:
· guarantees by the seller for non-payment (bad debt credit risk), up to a certain limit or full default amount;
· a call option by the transferor (for example, to repurchase defaulted receivables);
· a put option by the factor for any defaulted assets; or
· the seller agreeing to pay interest to the buyer for any overdue receivables (late payment risk).
In some cases, the recourse provisions result in the transferor retaining substantially all the risks and rewards of ownership of the receivables, with the effect that the entity continues to recognise the factored receivables. In other cases, the recourse provisions result in the transferor retaining some, but not substantially all, risks and rewards, in which case the control test must be considered. In most factoring arrangements that are subject to recourse, the transferee is precluded from selling the receivables, which means that the transferor continues to control them. Therefore, continuing involvement accounting might apply.
Example 4 – Factor of advance payments
In some transactions, the contract requires the customer to pay part or all of the consideration before the entity provides any goods or services. The entity might factor the rights to these future cash flows before the goods or services have been provided and the related receivable recognised. For example, an entity might factor a future operating lease receivable. If an entity factors such unrecognised receivables, the entity should recognise the factoring arrangement as financing (that is, it should recognise a liability for the amounts received from the factor), because there is no asset to de-recognise.
Consider a five-year maintenance contract, with payments to be billed annually in advance, or an operating lease contract with rentals due quarterly in advance. The entity has a contractual right to receive cash from the date when the contract is signed, even though it has provided no goods or services at that time.
Such contracts give rise to the question of when a financial asset for the amounts due under the contract should be recognised. No asset should be recognised until at least one of the parties has performed under the contract. Such an arrangement comprises two elements. The first element is the sale of goods or services, which is an executory contract and hence is not recognised until the goods or services are delivered. The second element is a loan commitment (being the agreement by the customer to pay in advance). The second element is outside the scope of IAS 39/IFRS 9. Hence, no financial asset is recognised for either of the elements prior to performance or draw-down of the upfront payment.
If the entity factors the future cash inflows before recognising the receivable (for example, before the goods and services have been delivered), the entity should recognise a financial liability for the amounts received from the factor.
Example 5 – Factoring receivables already subject to credit insurance
In some instances, an entity might have already obtained credit insurance for a portfolio of receivables prior to factoring them. On factoring, the factor becomes the beneficiary of the credit insurance. The question arises as to what is the ‘original asset’ for the purpose of the de-recognition criteria. Is it only the receivables, or is it the receivables plus the credit insurance? In the absence of guidance within IAS 39/IFRS 9, the term ‘original asset’ can be interpreted to mean either:
· all related contracts, including purchased options, swaps and insurance contracts, transferred with the loans/receivables in a single transaction that share and mitigate some of the risks on the loans because those are the cash flows that will be paid to the factor; or
· only the transferred loans/receivables themselves.
An entity must choose one of these two approaches as its accounting policy and apply it consistently throughout the de-recognition assessment.
For the factoring transaction, the latter approach is more likely to result in de-recognition. This is because the asset is viewed as uninsured receivables that are likely to have significant credit risk. Since this credit risk is transferred to the factor, it is more likely that the transaction will pass the risks and rewards test. Under the first approach, the asset is viewed as credit insured receivables that are likely to have lower credit risk. Therefore, any risk retained by the seller (other than that covered by the credit insurance) will be relatively more significant.
It should be noted that there is a separate question as to whether the credit insurance contract has been transferred, and the answer to that will depend on the facts and circumstances.
Securitisations
Securitisation is a method of raising finance. Securitisations were first used by originators of mortgage loans through a sale of a block or pool of loans. These sales are typically to a subsidiary or a thinly capitalised vehicle specially set up for the purpose – a special purpose entity (SPE). The SPE finances the purchase by issuing loan notes or other marketable debt instruments to outside investors that are often secured on the SPE’s assets. This process is also referred to as asset-backed finance.
In addition to pools of loans, other pools of debts are securitised in a similar way to mortgages. Examples include credit card receivables, leases, hire purchase loans and trade debtors. An SPE structure isolates the assets legally from the transferor and its creditors (‘ring-fence’). This helps to avoid any consequences from bankruptcy and enables the originator to raise funds at competitive rates. The following outlines a typical securitisation transaction:
· The assets to be securitised are transferred by an originator/transferor to an SPE for an immediate cash payment. The SPE finances the transfer by issuing loan notes to investors.
· The SPE’s shares or residual beneficial interests, if any, are usually held by a party other than the originator (charitable trusts have often been used for this purpose). In addition, the major financial and operating policies are usually pre-determined, to a greater or lesser extent, by the agreements that establish the securitisation (in other words, the SPE operates on so-called ‘autopilot’).
· Because the SPE’s business activities are constrained and its ability to incur debt is limited, it faces the risk of a shortfall of cash below what it is obligated to pay to investors. Arrangements are, therefore, made to protect the investors from losses occurring on the assets by a process termed ‘credit enhancement’.
A commonly used form of credit enhancement occurs via the issue of subordinated debt (perhaps to the transferor) and other forms of equity-like claims that have the effect of dividing the risk of loss on the underlying assets (‘tranching’).
Credit enhancement might take a variety of other forms, including overcollateralisation (the aggregate value of assets transferred exceeds the consideration provided by the SPE), third-party guarantee of the issuer’s obligations (securities backed by a letter of credit) or third-party credit insurance. All of the arrangements provide a cushion against losses up to some limit.
· The transferor is often granted rights to cash remaining from the transferred assets, after payment of amounts due on the loan notes and other expenses of the issuer. These rights are generally intended, at least in part, to compensate the transferor for assuming some of the risk of credit or other losses. The mechanisms used to achieve this include servicing or other fees, deferred sale consideration, ‘super interest’ on amounts owed to the transferor (for example, subordinated debt), dividend payments and swap payments.
· Cash accumulation from the assets (for example, from mortgage redemptions) is either used to redeem the loan notes or it is reinvested in other more liquid assets until the loan notes are repaid. Any surplus cash usually accrues to the transferor, as noted above.
· The transferor might continue to service the assets (for example, collecting amounts from the borrower, and setting interest rates) for which it might receive a ‘servicing fee’. Often, the surplus cash mentioned above is extracted by an adjustment to the service fee.
In many situations, the SPE will be no more than an extension of the originator, rather than an economic entity in its own right, and so it will be consolidated under IFRS.
Depending on the structure of the transaction, the sale of the financial assets by the originator to the SPE might also fail to qualify for derecognition. Most commonly, sales fail to qualify for de-recognition either because the pass-through conditions are not met (for example, if the securitisation is a ‘revolving structure’) or the selling entity has retained substantially all of the risks and rewards of ownership of the financial assets.
Credit enhancements provided by the transferor might impact whether de-recognition is achieved. An entity might provide the transferee with credit enhancement by subordinating some or all of its interest retained in the transferred asset. Alternatively, an entity might provide the transferee with credit enhancement in the form of a credit guarantee that could be unlimited, or limited to a specified amount. Credit enhancement techniques are often used in securitisation transactions, but they can also be used in other forms of financial asset transfers. If an entity has either transferred the contractual rights of the asset or assumed an obligation to pay the cash flows to others that meets the pass-through tests, but still retains substantially all the risks and rewards of ownership of the transferred asset, the asset continues to be recognised in its entirety. If the entity retains some, but not substantially all, of the risks and rewards of ownership and has retained control, de-recognition is precluded to the extent of the amount of cash or other assets that the entity could be required to pay under the subordination or credit guarantee agreement.
Subordinated retained interests and credit guarantees
The provision of a credit guarantee will cause the pass-through tests of IAS 39/IFRS 9 to fail. De-recognition will therefore be prevented where the pass-through tests are applied. This is because any payments made by the transferor under the guarantee are not cash flows from the original asset. The existence of a credit guarantee fails the condition that the obligation to pay cash flows to the eventual recipient should be based on the collection of equivalent amounts from the original asset.
The retention of a subordinated interest in the transferred asset does not, in itself, cause the pass-through tests to fail. This is because it does not require the entity to make payments other than out of collections on the transferred assets. However, the retention of a subordinated interest is likely to result in the transferor retaining some of the risks and rewards of the asset.
In some securitisation structures an entity might retain an interest in the transferred assets in the form of the right to any ‘excess spread’. The excess spread is generally any cash left in the SPE after paying the noteholders their interest and principal and after any costs incurred by the SPE. The retention of such an interest does not cause the pass-through test to be failed where the SPE is consolidated. However, the retention is likely to result in the transferor retaining at least some of the risks and rewards of the assets.
A securitisation might contain a provision that enables a transferor to call back some of the assets securitised at a subsequent date. Restrictions might apply to these provisions. Such provisions are referred to as ‘removal of accounts provisions’ (ROAPs). Some ROAPs might allow the transferor unilaterally to specify the assets that can be removed. Other ROAPs might specify that the identification of assets for removal is done randomly or by the transferee. These provisions are typically included for business reasons. The transferor might wish to protect the credit rating of a securitisation vehicle in the event that one of the securitised assets defaults. Another transferor might want the ability to repurchase assets associated with operations to be discontinued or exited.
Removal of accounts provisions
A removal of accounts provision (ROAP) is effectively a call option enabling the transferor to insist on a return of some of the transferred assets. This means that the transferor has retained control over the transferred assets, provided that the transferee does not have the practical ability to sell the assets (which is usually the case in a securitisation). Therefore, if such a provision results in the entity neither retaining nor transferring substantially all the risks and rewards of ownership, de-recognition is precluded only to the extent of the amount subject to call/repurchase.
If the carrying amount and proceeds from the transfer of loan assets are C100,000, and any individual loan could be called back, but the aggregate amount of loans that could be repurchased could not exceed C10,000, C90,000 of the loans would qualify for de-recognition.
The transferor might enter into an interest rate swap with an SPE in a securitisation involving fixed rate assets. The transferor might undertake to receive the fixed rate interest on the transferred assets and pay a variable rate to the SPE. The SPE would then pay variable rate interest to noteholders. The swap does not prevent de-recognition if the SPE does not need to be consolidated and the payments on the swap are not conditional on payments being made on the transferred asset. However, the swap might result in the retention of some risks and rewards such as late payment risk.
Swaps
An interest rate swap has been entered into with an SPE in a securitisation involving fixed-rate assets. The terms of the swap mean that the transferor receives fixed rate interest on the transferred assets and pays a variable rate to the SPE. The SPE pays variable-rate interest to noteholders. If the SPE is consolidated and the pass-through tests apply, a swap would prevent derecognition. This is because the swap results in the transferor having an obligation to pay amounts to the eventual recipients (investors in the notes), even if it does not collect equivalent amounts from the assets. The swap might require a net payment to the SPE (that is then passed to noteholders) if interest rates rise so that the interest due on the notes exceeds that due on the assets. Hence, the pass-through test is failed and de-recognition is precluded.
Some kinds of financial assets cannot be sold in the same way as other assets. However, they can be transferred to third parties in return for an immediate cash payment. The transfer might be of the whole of a single loan, part of a loan, or of all or part of a portfolio of similar loans. The methods by which the benefits and risks of loans can be transferred vary between jurisdictions. From the issuer’s perspective it is necessary to assess whether the loan transfer, regardless of its form, results in the borrower being legally released from its obligations under the existing loan to determine whether the loan has been transferred.
Loan transfers
Common loan transfer methods include those described below, although there might be variations across different jurisdictions.
Example 1: Novation
Typically, under a novation the rights and obligations of the original lender (the transferor) under the loan agreement are cancelled and replaced by new ones. The main impact is a change of the lender’s identity. The transferor is released from its obligations to the borrower.
Such a novation will result in the transfer of the contractual rights to receive the financial asset’s cash flows. Therefore, in the absence of any side agreements, the transferor will de-recognise the loan in its entirety. Side agreements might include guarantees or other forms of recourse arrangement, forward purchase arrangements or options.
Example 2: Assignment
Under an assignment, the original lender’s (the transferor’s) rights to the future cash flows under the loan agreement are typically transferred to the third party (the assignee). The obligations, which might include warranty obligations to repair faulty goods, are not transferred. There are generally two types of assignment. The first is an assignment where the lender is required to give notice in writing to the borrower. In some jurisdictions, these are known as legal or open assignments. The second is an assignment where no notice is required to be given to the borrower. In some jurisdictions, these are known as equitable or silent assignments.
Where the lender is required to give notice in writing to the borrower, the transferee normally acquires a direct legal claim on the future cash flows under the loan agreement. If there are side agreements between the transferor and the transferee, the treatment might be different depending on the terms.
Where notice is not required to be given to the borrower, the borrower is not aware that the lender has transferred its rights to the cash flows to another party. Therefore, there is doubt as to whether the transferee has obtained the unconditional contractual rights to the cash flows of the transferred asset. In general, whether the contractual rights to the cash flows have been unconditionally transferred under such an assignment would depend on the law of the country that governs the assignment.
Both types of assignment are subject to equitable rights arising before notice is received. For example, a right of offset held by the borrower against the lender will be good against the assignee for any transactions undertaken before the borrower receives notice of the assignment.
Assignments might or might not leave the transferor with continuing involvement in the loans depending on whether there are any residual interests, recourse provisions, buyback provisions, etc. The issues that arise in assignments are very similar to debt factoring and securitisations, most of which involve an assignment.
Example 3: Sub-participation
Under a sub-participation, the lender enters into a non-recourse back-toback arrangement with a third party (the sub-participant). In exchange for a cash receipt of an amount equal to the whole or fully proportionate part of the loan, the lender passes on the cash flows (both interest and principal) collected on the loan to the sub-participant. Typically, all of the contractual rights and obligations legally remain with the transferor.
Like assignments, sub-participation might or might not leave the transferor with continuing involvement in the loans, depending on whether there are any residual interests, recourse provisions, buyback provisions, etc. Provided that the sub-participation meets all three of the pass-through conditions, there is no recourse to the transferor, and the transferor does not retain any significant risks and rewards of ownership of the loans, derecognition is appropriate.
Loan syndications
Sometimes, a single lender might not be able to fund a large loan required by a borrower. In those situations, it is quite common for a group of lenders to fund the loan jointly. This is usually accomplished by a syndication, under which several lenders share in lending to a single borrower. Each syndicate member lends a specific amount to the borrower and has the right to repayment from the borrower. Such a loan syndication is not a transfer of financial assets. Accordingly, each lender in the syndication should account for the amounts that it is owed by the borrower.
In some loan syndications, the lead lender might advance funds to the borrower and transfer a fully proportionate share of the loan to different lenders. The borrower makes repayments directly to a lead lender, who then distributes the collections to the other syndicate lenders in proportion to the amount lent. This situation is no different, in substance, from a subparticipation (that is, non-recourse back-to-back lending with a third party). De-recognition of the loans transferred to the different lenders would be appropriate if the lead lender is simply functioning as an agent, all of the syndicate lenders have fully proportionate shares of the total lending, and all of the pass-through conditions and risks and rewards conditions are met.
The presence of a derivative might prevent a transferor from derecognising a financial asset as discussed. The transferor’s contractual rights or obligations related to the transfer are not accounted for separately as derivatives if recognising both the derivative and either the transferred asset or the liability arising from the transfer would result in recognising the same rights or obligations twice.
Transfers involving derivatives
Transfers of financial assets often include derivatives, either explicitly or implicitly. Common derivatives that are found in transfer arrangements are put and call options, forward sale or repurchase contracts and swap agreements. Derivative instruments normally require exercise by one of the parties to the contract. In some instances, exercise of the derivative might be automatic. One example of this is where a transferor enters into a forward agreement to repurchase a transferred asset at a pre-determined price. In other instances, the exercise might be conditional on the occurrence of a particular event, such as where the transferee has the right to put back to the transferor receivables that remain uncollectable.
The existence of derivatives might not prevent de-recognition (for example, if the pre-determined price mentioned in the paragraph above is set at market price at repurchase date). In other circumstances, derivatives might well prevent a transferor from de-recognising a financial asset, thereby precluding sale treatment. Derivatives might also constrain a transferee’s practical ability to sell the transferred asset, even if there is no legal constraint, with the result that the transferor retains control over the transferred asset. Derivatives might act as an impediment to the transferee realising the economic benefits inherent in the transferred asset. Each transaction should therefore be carefully analysed to determine whether or not the transferor has retained control of the transferred asset.
A financial asset that is transferred subject only to a deep out-ofthe-money put option held by the transferee or a deep out-of-the-money call option held by the transferor is de-recognised. The transferor is deemed to have transferred substantially all the risks and rewards of ownership, because a deep out-of-the-money option is very unlikely to become in-the-money at the exercise date.
Transfers subject to deep out-of-the-money option
It might become probable, due to subsequent events or changes in market conditions, that a deep out-of-the-money put or call option is likely to be exercised at the exercise date. The change in probability of the option being exercised would not result in the re-recognition of a financial asset that has previously been de-recognised. This is consistent with the requirements in the standard. Where an entity determines that, as a result of the transfer, it has transferred substantially all the risks and rewards of ownership, it does not recognise the transferred asset again in a future period, unless it re-acquires the transferred asset in a new transaction. Instead, the option would be accounted for as a derivative at fair value, with the increase in its fair value reflected in profit or loss.
A financial asset that is readily obtainable in the market and transferred subject to the transferor holding a call option that is neither deeply in-the-money nor deeply out-of-the-money is de-recognised. The entity has neither retained nor transferred substantially all the risks and rewards of ownership and has not retained control. The transferor has a continuing involvement in the asset; however, because the asset is readily obtainable in the market the call option does not create any constraints on the transferee’s practical ability to sell the asset. If the transferred asset has been sold by the transferee and the transferor exercises the call option, the transferee will be able to fulfil its obligation by purchasing a replacement asset from the market. Therefore, the transferor retains no control over the transferred asset and de-recognition of the transferred asset is appropriate. The transferor will account for the call option as a derivative at fair value with changes in fair value reflected in profit or loss.
A transfer of a financial asset that is subject only to a put or call option or a forward repurchase agreement that has an exercise or repurchase price equal to the fair value of the financial asset at the time of repurchase results in de-recognition. There is transfer of substantially all the risks and rewards of ownership.
An entity might transfer a fixed rate financial asset to a transferee and enter into an interest rate swap with the transferee to receive a fixed interest rate and pay a variable interest rate based on a notional amount that is equal to the principal amount of the transferred financial asset. The interest rate swap does not preclude de-recognition of the transferred asset, provided that the payments on the swap are not conditional on payments being made on the transferred asset.
If a transferred financial asset can be called back by the transferor and the call option is deeply in-the-money, the transfer does not qualify for de-recognition. The transferor has retained substantially all the risks and rewards of the asset’s ownership, by virtue of the fact that the call option is so valuable that its exercise appears virtually assured at inception. Similarly, if the financial asset can be put back by the transferee and the put option is deeply in-the-money, the transfer does not qualify for derecognition because the transferor has retained substantially all the risks and rewards of ownership. Neither the call nor the put option is recognised separately, as to do so would result in double counting the same asset or obligation.
An entity might sell a financial asset to a transferee and enter into a total return swap with the transferee. The swap results in all of the cash flows from the underlying asset plus any increases and less any decreases in the underlying asset’s fair value being remitted to the entity in exchange for a fixed or variable rate payment. De-recognition of all of the asset is prohibited.
If an entity determines that a transfer of a financial asset qualifies as a transfer and qualifies for de-recognition because either:
De-recognition of a financial asset in its entirety
There might be instances where, as part of a transaction that results in a financial asset’s de-recognition, a new financial asset is obtained or a new financial liability is assumed. Any new asset is part of the proceeds of sale.
Any liability assumed, even if it is related to the transferred asset, is a reduction of the sales proceeds.
Entity A holds a small number of shares (classified as equity instruments) in entity B. The shares are recognised at fair value through other comprehensive income. On 31 March 20X6, the shares’ fair value is C130, and the cumulative gain recognised in other comprehensive income is C30. On the same day, entity B is acquired by entity C, a large quoted entity. As a result, entity A receives shares in entity C with a fair value of C130.
In this situation, the transfer of the shares in entity B qualifies for derecognition in their entirety, because the entity no longer retains any risks and rewards of ownership. In addition, the transfer results in entity A obtaining a new financial asset (that is, shares in entity C) that should be recognised at fair value. The gain on disposal is:
C Proceeds received (fair value of cash or other securities received) 130 + Fair value of any new financial asset acquired in the transfer – – Fair value of any new liability assumed in the transfer – Net proceeds 130 Carrying amount of the whole financial asset transferred (130) Gain (or loss) arising on de-recognition 0 Under IAS 39, the cumulative gain of C30 that had been previously recognised in other comprehensive income would be recycled to profit or loss. Under IFRS 9, the cumulative gain that had been previously recognised in other comprehensive income is not recycled to profit or loss.
The accounting entries to record the transfer under IFRS 9 are shown below:
Dr Cr C C Fair value of shares in entity C acquired 130 130 Carrying value of shares in entity B disposed of 130 130 Gain on disposal under IFRS 9 The accounting entries to record the transfer under IAS 39 are shown below:
Dr Cr C C Fair value of shares in entity C acquired 130 Carrying value of shares in entity B disposed of 130 Other comprehensive income (‘recycling’ of cumulative gain) under IAS 39 30
Gain on disposal under IAS 39 recognised in profit or loss 30
Factoring without recourse
Entity A (the transferor) holds a portfolio of receivables with a carrying value of C1 million. It enters into a factoring arrangement with entity B (the transferee), under which it transfers the portfolio to entity B in exchange for C900,000 of cash. Entity B will service the loans after their transfer, and debtors will pay amounts due directly to entity B. Entity A has no obligations whatsoever to repay any sums received from the factor, and it has no rights to any additional sums, regardless of the timing or the level of collection from the underlying debts.
In this example, entity A has transferred its rights to receive the cash flows from the asset via an assignment to entity B. Furthermore, because entity B has no recourse to entity A for either late payment risk or credit risk, entity A has transferred substantially all the risks and rewards of ownership of the portfolio. Hence, entity A de-recognises the entire portfolio. The difference between the carrying value of C1 million and cash received of C900,000, including any new asset obtained less any new liability assumed (for example, relating to servicing of the loans), is recognised immediately as a financing cost in profit or loss.
Sale of listed debt securities subject to a call option
On 1 January 20X6, bank A enters into an agreement to sell a portfolio of held-for-trading listed debt securities to an investment fund in exchange for a cash payment of C6 million. The securities are subject to a call option that allows the bank to repurchase the securities for a price of C6.7 million on 31 December 20X6. The securities’ fair value at the date of transfer is C6.5 million. The option’s fair value is C0.5 million. The investment fund has the practical ability to sell the securities to a third party. The presence of the call option means that the bank has a continuing involvement in the transferred asset. However, because the securities are listed and the investment fund has the practical ability to sell the securities to a third party unilaterally and without imposing any conditions, the bank has not retained control of the securities. Accordingly, the bank will derecognise the securities, but it will record its rights under the call option separately. Given that the call option’s strike price (C6.7 million) is more than the fair value of the underlying securities (C6.5 million), the call option is out-of-the-money. Therefore, the fair value of the call option of C0.5 million wholly relates to the time value of the option, which is also the premium paid by the bank. Therefore, at the date of transfer, bank A will record the following entries:
Dr Cr C’m C’m Cash 6.0 Trading portfolio 6.5 Derivative (call option) .05 Bank A will recognise the call option at fair value through profit and loss. At 31 December 20X6, the fair value of the securities increases to C7 million and the bank exercises the option. Bank A will record the following entries:
Dr Cr C’m C’m Derivative 0.2 Profit or loss 0.2 Trading portfolio 7.0 Cash 6.7 Derivative 0.3 Because 31 December 20X6 is the call’s expiry date, its time value at that date will be zero. The decline in the time value is included in the C0.2 million loss recognised in profit or loss.
On de-recognition of a financial asset in its entirety, the difference between the carrying amount (measured at the date of derecognition) and the sum of:
As an exception to the principle above, if the financial asset is an investment in an equity instrument which the entity elected to measure at fair value through other comprehensive income then under IFRS 9 any cumulative gain or loss is not recycled to profit or loss. Under IAS 39, there is no such exception – the cumulative gain or loss on any financial assets measured at fair value through other comprehensive income is recycled to profit or loss on de-recognition.
Transferred asset is part of a larger asset
An entity might transfer an asset that is part of a larger financial asset. One example is the transfer of interest-only cash flows that are part of a debt instrument. If the part transferred qualifies for de-recognition in its entirety, the previous carrying value of the larger financial asset is allocated between the part that continues to be recognised and the part that is derecognised. The allocation is based on the relative fair values of those parts at the date of transfer. For this purpose, a retained servicing asset should be treated as a component of the part that continues to be recognised. The difference between the carrying amount allocated to the part de-recognised and the sum of:
De-recognition of a part of a financial asset
On 1 April 20X2, an entity acquired corporate bonds at their face value of C5 million. The bonds pay interest of 8% per annum in arrears and are redeemable at par at the end of year 10 on 31 March 20Y2.
On 31 March 20X6, when the current market rate of interest was 6%, the fair value of the bonds amounted to C5,491,732, consisting of the present value of the interest-only strip of C1,966,930 and principal-only strip of C3,524,802. On the same date, the entity unconditionally transferred its right to the principal-only strip to a bank under a legal assignment for cash payment equal to its fair value without any recourse.
The entity retained the interest-only strip (that is, the right to receive interest income on the bond at C400,000 per annum for the remaining six years). The entity has transferred its rights to receive the principal cash flows to the bank via a legal assignment. Because the entity has unconditionally sold its right to repayment when the bond matures on 31 March 20Y2 without recourse, it has transferred the risks and rewards attributable to the principal-only strip that is part of a larger asset. Therefore, the entity can de-recognise the principal-only strip in its entirety.
In order to calculate the gain or loss on the principal-only strip, it is necessary to allocate the carrying amount of C5 million between the part sold and the part retained, based on their respective fair values. The allocation is shown below:
Fair value Percentage of fair value Allocated carrying amount C % C Principal-only (PO) strip 3,524,802 64.1838 3,209,190 Interest-only (IO) strip 1,966,930 35.8162 1,790,810 Total 5,491,732 100.0000 5,000,000 The accounting entries to record the part de-recognised are:
Dr Cr C C Cash received on sale of PO strip 3,524,802 Carrying amount attributable to PO strip 3,209,190 Gain on sale of PO strip 315,612 If the bond had been recognised at fair value through other comprehensive income, the bond would have been recorded at its fair value of C5,491,732 at 31 March 20X6. The amount credited to other comprehensive income would have amounted to C491,732. In that situation, it would be necessary to ‘recycle’ that portion of the fair value gain that is attributable to the principal-only strip to the income statement. This allocation should also be based on the relative fair values of the principal-only and interest-only strips. Therefore, the portion of the gain in other comprehensive income attributable to the principal-only strip which is to be recycled to the income statement amounts to C315,612 (64.1838% of C491,732).
The accounting treatment would be similar if, instead of unconditionally transferring the principal only strip at its fair value, the entity had transferred the interest-only strip (the right to receive future interest income) at its fair value and retained the principal-only strip. In that situation, a gain of C176,120 (C1,966,930 – C1,790,810) would have arisen on the transfer if the asset was carried at amortised cost. If the asset was carried at fair value through other comprehensive income, the ‘recycled’ gain to profit or loss would be C176,120 (35.8162% of C491,732).
In making an allocation of the previous carrying amount of a larger financial asset between the part transferred and the part that continues to be recognised, it is necessary to determine the fair value of the part that continues to be recognised. If the entity has a history of selling parts similar to the part that continues to be recognised, or other market transactions exist for such parts, recent prices of actual transactions provide the best estimate of its fair value. If there are no price quotes or recent market transactions to support the fair value of the part that continues to be recognised, the best estimate of the fair value is the difference between:
An entity applies the fair value measurement requirements discussed (IFRS 9) or Appendix (IAS 39) in estimating the fair values of the part that continues to be recognised and the part that is de-recognised.
Servicing assets and liabilities
An entity might transfer a financial asset in a transfer that qualifies for de-recognition in its entirety and retain the right to service the financial asset for a fee. The entity should recognise either a servicing asset or a servicing liability for that servicing contract as follows:
Servicing assets and liabilities
Servicing is inherent in all loans and receivables. Servicing of mortgage loans, credit card receivables or other financial assets commonly includes collecting payments as they fall due, accounting for and remitting principal and interest payments to the transferee, monitoring non-performing loans/debtors, executing foreclosure if necessary and performing other administrative tasks. The service provider incurs the costs of servicing the assets, often in return for a fee for performing the services.
Servicing rights do not meet the definition of a financial instrument, because they represent a commitment to supply a service and can only be settled by the service delivery. Servicing rights are essentially an expected stream of cash flows that results from a contractual agreement. Therefore, they are so similar to financial instruments that they are recognised and initially measured on the same basis as financial assets and liabilities. Where the benefits of servicing exactly compensate the service provider for its servicing responsibilities, there is no servicing asset or liability and the service contract’s fair value is zero.
Servicing assets and liabilities are subject to the measurement requirements of IFRS 13 when initially recognised.
Servicing assets or liabilities are subsequently amortised over the period of estimated net servicing income or net servicing loss. Subsequent measurement at fair value through profit or loss is precluded, because the fair value option is applicable only to financial items and, therefore, it cannot be applied to servicing rights.
An entity might retain the right to a part of the interest payments on transferred assets, as compensation for servicing those assets. The part of the interest payments that the entity would give up, on termination or transfer of the servicing contract, is allocated to the servicing asset or servicing liability. The part of the interest payments that the entity would not give up is an interest-only strip receivable. For example, if the entity would not give up any interest on termination or transfer of the servicing contract, the entire interest spread is an interest-only strip receivable. In respect of a transferred asset that is part of a larger financial asset, the fair values of the servicing asset and interest-only strip receivable are used to allocate the carrying amount of the receivable between the part of the asset that is de-recognised and the part that continues to be recognised. If there is no servicing fee specified, or the fee to be received is not expected to compensate the entity adequately for performing the servicing, a liability for the servicing obligation is recognised at fair value.
Sale of receivable with servicing retained (servicing fee not specified in the contract)
Entity A owns a portfolio of loans with a carrying amount of C5 million that yield 8% interest income. The loans are accounted for at amortised cost.
The entity sells the entire portfolio to a bank for C5.25 million without any recourse via a legal assignment. However, the entity agrees to service the portfolio over the remainder of its life for no additional payment, and it estimates that the amount that would fairly compensate it for servicing the portfolio is C200,000.
In this situation, because the entity transfers the entire portfolio, including its right to receive future interest income, on terms that qualify for derecognition, the entity would de-recognise the carrying value of the portfolio of C5 million. It would also recognise, in the absence of a servicing fee, a servicing liability of C200,000.
The accounting entries to record the transfer are:
Dr Cr C C Cash 5,250,000 Loans 5,000,000 Servicing liability 200,000 Gain on disposal 50,000
Sale of receivable with servicing retained (servicing fee specified in the contract)
Entity A owns a portfolio of loans with a carrying amount of C5 million that yield 8% interest income. The loans are accounted for at amortised cost. The entity transfers the entire principal amount of the portfolio, plus its right to receive interest income of 6%, via a legal assignment for a consideration of C4,900,000. The transfer is without any recourse.
The entity retains the right to service the portfolio, for which it will be compensated through a right to receive one-half of the interest income not sold (that is, 1% of the 2% future interest income retained). The remaining 1% is considered to be an interest-only strip retained by entity A. At the date of transfer, the fair value of the interest-only strip is C275,000 and the fair value of the servicing asset is C75,000. This servicing asset is calculated as the present value of the servicing fee receivable less a market fee for performing the service.
It is necessary to consider whether the criteria for de-recognition should be applied to the portfolio of loans in its entirety or to separate portions. It is assumed that 75% (6% out of the 8%) of the interest cash flows transferred represents a full proportionate share of all of the interest cash. This means that the entity will consider two portions of the whole portfolio, being 100% of the principal cash flows and 75% of the interest cash flows, separately for the purposes of de-recognition.
In this example, the rights to the cash flows have not expired, because the loans still exist. Therefore, it is necessary to consider whether the entity has transferred its rights to receive the cash flows from the asset. However, the entity has legally assigned its rights to all of the principal cash flows and the 6% interest cash flows from the portfolio to the bank. Even though it has retained the rights to service the portfolio, this, in itself, does not prevent the transfer of the contractual rights to receive cash flows from the loans. Since the transfer was made without any recourse, entity A has transferred substantially all the risks and rewards of those portions. Therefore, entity A would de-recognise the transferred portions.
In order to calculate the gain or loss arising on the transfer, the carrying amount of the financial asset (the portfolio of loans) of C5 million should be allocated between the part sold and the part retained, based on their relative fair values. In this regard, the servicing asset is allocated to the part that continues to be recognised.
Fair value Percentage of fair value Allocated carrying amount Interest sold/retained C % C Loan sold (principal and 6% interest) 4,900,000 93.33 4,666,500 Interest-only strip retained 275,000 5.24 262,000 Servicing asset 75,000 1.43 71,500 Total 5,250,000 100.00 5,000,000 The gain arising on sale of the portion de-recognised is the difference between the sales proceeds of C4,900,000 and the allocated carrying amount of C4,666,500 (that is, C233,500). The retained interest in the transferred asset consists of an interest-only strip of C262,000 plus a servicing asset of C71,500 (that is, C333,500).
If a transfer does not result in the transferred asset’s derecognition, the entity continues to recognise the transferred asset in its entirety. The entity also recognises a financial liability for the consideration received.
The asset recognised if a transfer does not result in derecognition and the associated liability cannot be offset. The entity recognises any income on the transferred asset and any expense incurred on the financial liability in subsequent periods. The entity cannot offset the income and the expense.
Factoring with full recourse
The requirement not to net financial assets which have not been derecognised and the related liabilities reflects the transaction’s substance (that is, a collateralised borrowing).
The treatment only applies when a financial asset is precluded from being de-recognised. It does not apply where a financial asset is not derecognised, because the entity has a continuing involvement in the financial asset. In those circumstances, special provisions apply.
Entity A (the transferor) holds a portfolio of receivables with a carrying value of C1 million. It enters into a factoring arrangement with entity B (the transferee), under which it transfers the portfolio via an assignment to entity B in exchange for C900,000 of cash. All sums collected from debtors are paid by entity A to a specially nominated bank account opened by entity B. Entity A is only servicing the loans and has no right to the cash flows. Entity A agrees to reimburse entity B in cash for any shortfall between the amount collected from the receivable and the consideration of C900,000. Once the receivables have been repaid, any sums collected above C900,000 less interest on the initial payment until the date when debtors pay, will be paid to entity A.
In this example, entity A has transferred its rights to receive the cash flows from the asset.
The next step is to consider whether entity A has transferred substantially all the risks and rewards of ownership of the receivables. Under the factoring arrangement, entity A’s maximum possible exposure to entity B is to repay all of the C900,000 consideration. Although this situation is unlikely, it means that entity A has given a guarantee to compensate the transferee for all credit losses that are likely to occur. In addition, entity A receives the benefit of sums collected from debtors above C900,000. Consequently, entity A has retained both the credit and late payment risk associated with the receivables. Entity A has therefore retained substantially all the risks and rewards of ownership of the receivables, and it continues to recognise the receivables.
Entity A recognises the consideration received of C900,000 as a secured borrowing. The liability is measured at amortised cost, with interest expense recognised over the period to maturity of the receivables in line with the interest rate charged by the factor.
Subordinated retained interests and credit guarantees
An entity might provide the transferee with credit enhancement by subordinating some or all of its interest retained in the transferred asset. Alternatively, an entity might provide the transferee with credit enhancement in the form of a credit guarantee that could be unlimited or limited to a specified amount. If the entity retains substantially all the risks and rewards of ownership of the transferred asset, the asset continues to be recognised in its entirety.
Subordinated retained interest
Entity A originates a portfolio of five year interest-bearing loans of C10 million. Entity A then enters into an agreement with entity B. In exchange for a cash payment of C9 million, entity A agrees to pay to entity B the first C9 million (plus interest) of cash collected from the loan portfolio. Entity A retains rights to the last C1 million (plus interest). Expected collections on the loan portfolio are C9.5 million, and experience suggests that they are unlikely to be less than C9.3 million.
Entity A’s retained interest in the cash flows from the loans is effectively subordinated. If entity A collects only C8 million of its C10 million loans, because some debtors default, entity A would have to pass on to entity B all of the C8 million collected and keep nothing for itself. On the other hand, if entity A collects C9.5 million, it passes C9 million to entity B and retains C0.5 million.
Entity A retains substantially all the risks and rewards of ownership of the loans, because the subordinated retained interest absorbs all of the likely variability in net cash flows. The loans continue to be recognised in their entirety, even if the three pass-through criteria are met. This is because derecognition is only achieved where substantially all the risks and rewards of ownership are transferred as well. Since de-recognition is not achieved, the entire proceeds of C9 million are recorded as a collateralised borrowing.
Where the entity transfers some significant risks and rewards and retains others and de-recognition is precluded because the entity retains control of the transferred asset, the entity continues to recognise the asset to the extent of its continuing involvement. The continuing involvement should be measured in such a way that ensures that any changes in value of the transferred asset that are not attributed to the entity’s continuing involvement are not recognised by the entity. The extent of the entity’s continuing involvement in the transferred asset is the extent to which it is exposed to changes in the transferred asset’s value. Measuring a financial asset to the extent of the entity’s continuing involvement might not be in accordance with the general measurement rules for financial assets. However, it is necessary to ensure that the accounting properly reflects the transferor’s continuing involvement in the asset. Examples of continuing involvement include full or partial guarantees of the collectability of receivables, conditional or unconditional agreements to re-acquire the transferred assets and written or held options.
Associated liability
An entity that continues to recognise an asset to the extent of its continuing involvement also recognises an associated liability. The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability is:
Background to associated liabilities
The measurement basis for an associated liability might often result in a liability amount on initial recognition that is a ‘balancing figure’. This will not necessarily represent the proceeds received in the transfer. This is in contrast to the treatment for transfers that do not qualify for de-recognition through retention of risks and rewards, where the entire proceeds are accounted for as collateralised borrowing. Special rules are necessary to account for transfers involving continuing involvement. The standard acknowledges that this is not consistent with other requirements to reflect the rights and obligations that the entity has retained.
Subsequent measurement
The fair value of the transferred asset and the associated liability subsequent to initial recognition should be accounted for consistently with each other, in accordance with the general provisions for measuring gains and losses. Designation of the associated liability at fair value through profit or loss is not available if the asset is measured at amortised cost.
A transferred asset and the associated liability cannot be offset. Income on a transferred asset and expenses incurred on the associated liability cannot be offset.
The entity should continue to recognise any income arising on the transferred asset to the extent of its continuing involvement. It should also recognise any expense incurred on the associated liability.
Continuing involvement through guarantees
An entity might provide a guarantee to pay for default losses on a transferred asset. That guarantee prevents the transferred asset from being de-recognised to the extent of the entity’s continuing involvement. The entity’s continuing involvement in the transferred asset is the extent to which the entity continues to be exposed to the changes in the value of the transferred asset and the associated liability. If the transferred asset was originally measured at amortised cost, the continuing involvement is measured as follows:
Subsequently, the initial fair value of the guarantee is recognised in profit or loss on a time proportion basis, and the asset’s carrying value is reduced by any impairment losses. If the guarantee is subsequently called, the liability is reduced by the cost of settlement. To the extent that the guarantee is not called and the entity is no longer exposed to the changes in the value of the transferred asset (that is, the guarantee has lapsed unexercised), both the asset and the liability are reduced.
Factoring with limited recourse (late payment risk retained)
Entity A (the transferor) holds a portfolio of trade receivables with a carrying value of C500 million. Entity A enters into a factoring arrangement with entity B (the transferee), under which it transfers the portfolio to entity B in exchange for C490 million of cash. Entity A transfers the credit risk, but it retains the late payment risk up to a maximum of 180 days. After 180 days, the receivable is deemed to be in default, and credit insurance takes effect. A charge is levied on entity A for these late payments, using a current rate of 6%. The fair value of the guarantee of late payment risk is C2 million. Apart from late payment risk, entity A does not retain any credit or interest rate risk, and it does not carry out any servicing of the portfolio. There is no market for the receivables.
Entity A has transferred some but not all the risks and rewards of ownership. It has retained late payment risk, but it has transferred credit risk. Since there is no market for the receivables, entity B does not have the practical ability to sell the transferred asset. Therefore, because entity B is constrained from selling the asset, the ‘practical ability’ test fails, with the result that control of the transferred asset is retained by entity A. As a result of the above, entity A determines that it has a continuing involvement in the transferred receivables.
Entity A measures the continuing involvement in the transferred asset at the lower of:
· the carrying amount of the transferred asset (C500 million); and
· the maximum amount of the consideration received in the transfer that entity A could be required to repay (6% on C500 million for 180 days = 6% × 500 × 180/360 = C15 million), the guaranteed amount.
Entity A will, therefore, record the continuing involvement asset at C15 million.
Entity A will measure the associated liability initially at the guarantee amount (C15 million) plus the fair value of the guarantee (C2 million), a total of C17 million. The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability are equal to the fair value of the guarantee. Therefore, entity A would make the following entries at the date of transfer:
Dr Cr C’m C’m Consideration received in cash 490 Receivables transferred 500 Continuing involvement in transferred asset 15 Liability 17 Profit or loss – loss* 12 *Consideration received of C490 million – (consideration for guarantee C2 million + carrying value of portfolio C500 million). The above double entry shows a credit to receivables of C500 million and a debit of C15 million for the new continuing involvement asset. In practice, these entries would be combined (that is, a credit of C485 million to receivables), because the continuing involvement asset is a retained part of the transferred loans, and not a new asset. Entity A would make the following accounting entries subsequent to the date of transfer:
(i) To amortise the consideration for the guarantee over the period to which it relates (180 days):
Dr Cr C’m C’m Liability 2 Profit or loss 2 (ii) If the guarantee were to lapse unexercised, the following entries would be made over the period for which late payment risk is retained, because the maximum amount that entity A could be required to repay reduces due to timely payment on the receivables transferred:
Dr Cr C’m C’m Continuing involvement in transferred asset 15 Liability 15 (iii) When late payment occurs, such that a charge is levied by entity B (taking an example charge of C4 million), entity A would make the following entries:
Dr Cr C’m C’m Asset (to recognise the impairment of the continuing involvement asset) 4 Profit or loss 4 (iv) The following entries would be made when a late payment charge is actually paid by entity A (taking an example charge of C4 million):
Dr Cr C’m C’m Liability 4 Cash 4 In some factoring transactions, the entity transfers receivables without receiving cash from the factor on the date of transfer and retains late payment risk. However, the entity has a right to draw down cash from the factor of up to a specified amount during the life of the factoring. In such a case, the entity should recognise a continuing involvement asset and liability for the late payment risk retained, calculated as explained in the example above. In addition, the entity should record a receivable from the factor, measured at the sum of the total fair value of the receivables at the date of transfer and the fair value of the late payment guarantee. This will give a similar accounting result as if cash of this amount had been received on the date of transfer.
Sale of loans with credit risk guarantee
Background and assumptions
Entity P has originated a group of similar five-year fixed-rate corporate loans for C9,980,000, with the intention of selling them to a bank in the near future. It is therefore accounting for these loans at fair value through profit or loss before the sale. Subsequently, entity P assigns the loans to a third-party bank for C10.1 million, but it guarantees one-third of any default losses associated with the loans (under the terms of the guarantee, if a payment on a loan is 180 days overdue, the loan is considered to have defaulted and a payment becomes due under the guarantee). There is no active market in these loans. Credit risk is the only significant risk. There is no late payment risk, because interest is charged on late payments.
Note that continuing involvement is a unique accounting model for which little guidance is provided in IAS 39/IFRS 9. There could therefore be other acceptable ways to account for the following transaction.
Additional information
Fair value of loans:
· C10 million (fair value = book value, originated for C9,980,000, so the fair value has increased by C20,000 since origination).
· Fair value of guarantee obligation: C100,000.
· Fair value of guarantee fee: C57,000 (the present value of the 13bp fee on the outstanding principal balance).
· The servicing fee is expected to adequately compensate entity P for servicing the loans.
· The debtors have not been notified that their loans are being transferred.
Analysis using the flow chart
Step 1 Consolidate all subsidiaries
There are no SPEs involved. Entity P has sold the loans directly to the bank.
Step 2 Determine whether the de-recognition model should be applied to part of a financial asset (or a group of similar financial assets) or a financial asset (or a group of similar financial assets) in its entirety
The financial instruments being transferred have similar characteristics. They are all fixed-rate loans to similar counterparties that mature at approximately the same time (five years). They can be assessed as a group of similar financial assets in their entirety.
Step 3 Have the rights to the cash flows expired?
No, the portfolio of loans has not yet reached maturity, so the rights to the cash flows still exist.
Step 4 Is there a transfer?
Yes, entity P has assigned the loans to the bank. In addition, although the debtors have not been notified that their loans have been transferred, this does not preclude this transaction from meeting the definition of a transfer, because entity P is only servicing the loans and has no rights to cash flows (other than the servicing fee of 13bp).
Step 5 Risks and rewards analysis
Entity P has retained one-third of any credit losses that are incurred by the bank on these loans. Entity P has not retained any other risk on these loans. Therefore, entity P has retained some risks and rewards, since credit risk is the only significant risk, but not substantially all risks and rewards, and should ask the control question.
Step 6 Control
The bank does not have the ability to sell the loans unilaterally. There is no market in the loans and, because the loans are subject to the guarantee, the bank would want to also sell the loans subject to that guarantee. That additional restriction means that entity P still controls the loans. Therefore, entity P will continue to recognise the loans to the extent of its continuing involvement.
Transferor’s accounting
Entity P has neither retained nor transferred substantially all of the risks and rewards relating to the loans and has retained control; it should therefore account for the transfer using continuing involvement. The continuing involvement is the lower of (a) the amount of the asset, and (b) the maximum amount of the consideration received that the entity could be required to repay (‘the guarantee amount’):
· The amount of the asset equals C10 million.
· The maximum amount of the consideration received (C10.1 million) that the entity could be required to repay – the guaranteed amount – is one-third of the principal balance and amounts to C3,333,333.
The continuing involvement asset is therefore C3,333,333 (the lower of (a) and (b)).
The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability is equal to the fair value of the rights and obligations retained by the entity when measured on a stand-alone basis, in accordance with IAS 39 / IFRS 9.
The entity has the obligation to provide a guarantee for one-third of credit losses. The fair value of the guarantee obligation is C100,000. Accordingly, the liability is C3,433,333, being the aggregate of the amount of the continuing involvement asset above (C3,333,333) and the guarantee amount (C100,000).
Accounting entries on origination of the loans
Dr Cr C C Cash 9,980,000 Loans 9,980,000 to record the cash lent at origination of the loan.
Accounting entries just before transfer, as fair value of loans has increased
Dr Cr C C Loans 20,000 Profit or loss 20,000 to record the increase in the fair value of the loans.
Accounting entries on date of the transfer
Dr Cr C C Cash 10,100,000 Loans (to record the cash received on the sale of the loans) 10,000,000 Continuing involvement asset (inclusive of the guarantee receivable of 57,000) 3,333,333 Continuing involvement liability (inclusive of the guarantee liability of 100,000) to record entity P’s continuing involvement in the loans resulting from the guarantee. 3,433,333 For illustrative purposes, we have shown a credit to the loans of C10 million and a debit of C3,333,333 for the new continuing involvement asset. In practice, these entries would be combined, because the continuing involvement asset is a retained part of the transferred loans – it is not a new asset. There is no gain or loss on disposal, since the assets were already carried at fair value.
Subsequent accounting
Subsequently, the continuing involvement asset will continue to be measured at fair value through profit or loss. To the extent that there is an expected pay-out under the guarantee, this will be reflected by a negative fair value change in the asset, and so the net of the continuing involvement asset and liability will reflect the fair value of the guarantee. In addition, since amounts are collected on the loans, both the continuing involvement asset and liability are similarly reduced.
Assume that we are one year later, and the fair value of the loans has decreased by C384,000, of which we still have continuing involvement in one-third, and the fair value of the guarantee is now C174,000:
Dr Cr C C Continuing involvement assets (reflecting the change in fair value of assets) (one third of 384,000) 128,000 Continuing involvement liability (reflecting the change in fair value of assets and increase in fair value of guarantee: 128,000 – 74,000) 54,000 Net profit and loss 74,000 to record the cash fee received for the guarantee, the fall in the fair value of the asset and the increase in the fair value of the liability.
Note that an alternative way to look at this might be to separately assess two transfers of proportions of the asset for de-recognition – one without recourse (67% of the asset), and the other with recourse (33% of the asset) which would achieve similar accounting in this example.
Continuing involvement through options
Derivatives included in the transfer might constrain the transferee’s practical ability to sell the transferred asset, even if there is no legal constraint. The transferor therefore retains control over the transferred asset. If the entity has neither transferred nor retained substantially all the risks and rewards of ownership of the transferred asset, it retains a continuing involvement in the transferred asset. This is the case where an entity transfer is a financial asset that is not readily obtainable in the market and holds a call option or writes a put option that is neither deeply in nor deeply out-of-the money at the date of transfer.
The entity’s continuing involvement might take the form of a written or purchased option (or both) on the transferred asset. The extent of the entity’s continuing involvement is the amount of the transferred asset that the entity might repurchase. However, if the transferor writes a put option on a transferred asset that is measured by the transferor at fair value, the extent of the entity’s continuing involvement is limited to the lower of the fair value of the transferred asset and the option exercise price. The transferor will not benefit from changes in the fair value above the option’s exercise price.
The manner in which the options are settled (physical or cashsettled) does not affect the measurement of the continuing involvement asset.
If a put option obligation written by an entity, or a call option held by an entity, prevents a transferred asset from being de-recognised and the entity measures the transferred asset at amortised cost, the associated liability is measured at its cost (that is, the consideration received). The cost of the transferred asset is adjusted for the amortisation of any difference between that cost and the amortised cost of the transferred asset at the option’s expiration date. If the option is exercised, any difference between the associated liability’s carrying amount and the exercise price is recognised in profit or loss.
Asset measured at amortised cost subject to call option held by the transferor
Entity A has a portfolio of high-yielding corporate bonds with an amortised cost carrying value of C102 million. The bonds are not traded in the marketplace and are not readily obtainable. On 1 January 20X6, entity A sells the bonds to entity B for a consideration of C100 million. Entity A retains a call option to purchase the portfolio for C105 million on 31 December 20X6. On that date, the amortised cost of the bonds will be C106 million. The fair value of the bonds, at the date of transfer amounted to C104 million.
The rights to receive cash flows from the asset have not expired. However, entity A has transferred its right to receive cash flows (interest and principal on the bonds) to entity B. In this situation, the bonds are transferred, subject to a call option that is neither deeply in-the-money nor deeply out-of-the money (the option’s exercise price is C105 million, compared to fair value of the asset of C104 million). The result is that the entity neither transfers nor retains substantially all the risks and rewards of ownership of the bonds.
Because the transferee does not have the practical ability to sell the bonds, de-recognition of the bonds is precluded to the extent of the amount of the asset that is subject to the call option, because the entity has retained control of the asset. Because entity A has an option to buy back all of the bonds, it continues to recognise the bonds at their amortised cost. The amortised cost will accrete from a carrying value of C102 million to C106 million at 31 December 20X6, using the effective interest rate method. The initial carrying amount of the liability is recorded at cost (that is, the consideration received of C100 million). The liability is then accreted to C106 million using the effective interest rate method, which is the amortised cost of the transferred asset at the expiration date of the option (not the option’s exercise price of C105 million). As the asset is measured at amortised cost, the liability is also measured in a consistent manner.
Therefore, entity A would make the following entries:
Dr Cr C’m C’m At 1 January 20X6 (date of transfer) Cash 100 Associated liability 100 For the period to 31 December 20X6 Bonds carried at amortised cost 4 Income from bonds (106 − 102) 4 Interest on liability (106 − 100) 6 Liability carried at amortised cost 6 At 31 December 20X6, entity A will exercise the option if the option exercise price of C105 million is less than the fair value of the bonds. In that situation, entity A would record the following entries:
Dr Cr C’m C’m Liability 106 Cash (exercise price of option) 105 Gain on exercise of option 1 On the other hand, if the strike price was C107 million and the option lapses unexercised, both the asset and the liability are de-recognised:
Dr Cr C’m C’m Liability 106 Carrying value of the bond 106
A similar analysis would be carried out if, instead of purchasing a call option, entity A wrote a put option that gave entity B the right to put the bonds back at 31 December 20X6.
If a call option right held by the entity prevents a transferred asset from being de-recognised and the entity measures the transferred asset at fair value, the transferred asset continues to be measured at fair value. The call option gives the entity access to any increase in the asset’s fair value. However, the measurement of the associated liability depends on whether the call option is in or out-of-the money, as described below.
The effect of the above measurement basis is to ensure that the associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability are always equal to the fair value of the call option right.
Asset measured at fair value subject to call option held by the transferor
Entity A has a 15% equity holding in entity B (classified as an equity instrument) that was acquired some years ago for C40 million. This holding is measured at fair value through other comprehensive income, and the current fair value (and carrying value) is C104 million. There is no active market in entity B’s shares. On 1 January 20X6, entity A sells its 15% investment in entity B to bank C for a consideration of C100 million, but it retains a call option to purchase the investment for C105 million on 31 December 20X7.
The rights to receive cash flows from the asset have not expired. Entity A has transferred its right to receive cash flows (dividends on the shares) from its investment to bank C, subject to a call option. The result is that the entity neither transfers nor retains substantially all the risks and rewards of ownership of the transferred asset. This is because entity A:
· can exercise its call option so as to benefit from movements in the asset’s fair value above the call option exercise price of C105 million; and
· is not exposed to risk from decreases in the asset’s market value below the call option exercise price.
Whether entity A has retained control of its investment in entity B will depend on whether bank C has the practical ability to sell the asset in its entirety to an unrelated third party, unilaterally and without imposing additional restrictions on the transfer. In this situation, there is no active market in entity B’s shares, so a 15% stake is not readily obtainable in the market. The call option is neither deeply in-the-money nor deeply out-of-the-money (it is slightly out-of-the-money at inception because the option exercise price of C105 million is more than the market value of the shares at C104 million). The option is sufficiently valuable to prevent bank C from selling the asset immediately. These facts, taken together, lead to the conclusion that bank C does not have the practical ability to sell its investment in entity B. Consequently, entity A has retained control, and de- recognition is precluded to the extent of the amount of the asset that is subject to the call option.
Entity A continues to recognise the investment in entity B as an asset at fair value through other comprehensive income. Because there is no derecognition, there is no recycling of cumulative gains or losses under IAS 39. At the date of transfer, the call option is out-of-themoney, because the option’s exercise price of C105 million is greater than the fair value of the asset at C104 million. The premium paid on the option (all time value) is C4 million (fair value of the asset of C104 million less consideration received of C100 million). Because the option is out-of-themoney, the associated liability should be measured at the fair value of the transferred asset less the time value of the option. Therefore, the associated liability is recorded at C100 million (C104 million less C4 million), which is also equal to the consideration received. This ensures that the net amount of the transferred asset and the associated liability is equal to the fair value of the call option right. Therefore, entity A would make the following entries:
Dr Cr C’m C’m At 1 January 20X6 (date of transfer) Cash 100 Associated liability 100 Suppose that the asset’s fair value increases to C106 million at 31 December 20X6. The option is now in-the-money (exercise price of C105 million < C106 million) and its time value is C2 million. The associated liability is measured at the option’s exercise price (C105 million) less the time value of the option (C2 million), so C103 million. This ensures that the net amount of the transferred asset (C106 million) and the associated liability (C103 million) is equal to the fair value of the call option right of C3 million (intrinsic value of C1 million + time value of C2 million). Entity A will record the following entries at 31 December 20X6:
Dr Cr C’m C’m Asset (increase in value from C104m to C106m) 2 Liability (increase in value from C100m to C103m) 3 Other comprehensive income 1 The associated liability should be measured in a manner consistent with the asset, in accordance with the general provisions for measuring gains and losses. The movement in the liability is also recognised in other comprehensive income. The net loss of C1 million recognised in other comprehensive income represents the fall in the value of the option from C4 million to C3 million.
It should be noted that, to the extent that a transfer of a financial asset does not qualify for de-recognition, the transferor’s contractual rights or obligations related to the transfer are not accounted for separately as derivatives. This is because recognising both the derivative and the transferred asset would result in recognising the same rights twice. Therefore, entity A does not recognise the call option separately. Suppose that the fair value of the asset remains unchanged at 31 December 20X7. The entity will exercise the option, because it is in-the-money. The accounting entries are:
Dr Cr C’m C’m Liability de-recognised 103 Other comprehensive income 2 Cash paid 105 The overall loss of C3 million over the two-year period is recognised in other comprehensive income. This represents the difference between the amount paid to re-acquire the asset for C105 million and the consideration received on the transfer of C100 million, less the increase in the fair value of the asset of C2 million (C106 million − C104 million) already recognised in other comprehensive income. It forms part of the cumulative net gain in other comprehensive income relating to the 15% equity holding in entity B.
Suppose that the fair value of the asset falls to C103 million at 31 December 20X7. In this situation, entity A will not exercise the option and will allow it to lapse. At the date of the de-recognition, entity A will remeasure the asset to the fair value of 103. The accounting entries are: Dr Cr C’m C’m Asset (decrease in value from C106m to C103m) – 3 Other Comprehensive income 3 –
Next, both the transferred asset and the associated liability will be derecognised. The entries under IFRS 9 are shown below:
Dr Cr C’m C’m Liability 103 – Asset – 103 Gain on disposal – – Under IFRS 9, the cumulative gain that had been previously recognised in other comprehensive income is not recycled to profit or loss. Under IAS 39, the cumulative gain of C60m (C103m fair value – C40m original cost – C3m time value of the option) that had been previously recognised in other comprehensive income would be recycled to profit or loss. The entries under IAS 39 are shown below:
Dr Cr C’m C’m Liability 103 – Asset – 103 Other comprehensive income (recycling of cumulative gain) under IAS 39 60 – Gain (or loss) under IAS 39 profit or loss – 60 Under IAS 39, the gain of C60 million represents the net cash received of C60 million (consideration received of C100 million less original cost of C40 million).
A put option written by an entity might prevent a transferred asset measured at fair value from being de-recognised. The transferred asset is measured at the lower of the fair value and the option exercise price. This limitation is placed on the asset value, because the entity has no right to the increase in the asset’s fair value above the option exercise price. The associated liability is measured at the option’s exercise price plus the time value of the option. This ensures that the net carrying amount of the asset and the associated liability are always equal to the fair value of the put option obligation.
Asset measured at fair value subject to put option written by the transferor
Entity A has a 15% equity holding in entity B that was acquired some years ago for C40 million. This holding is recognised at fair value through other comprehensive income and the current fair value at 1 January 20X6 (and carrying value) is C97 million. There is no active market in entity B’s shares.
On 1 January 20X6, entity A sells its investment in entity B to bank C for consideration of C102 million. However, entity A has granted a put option to bank C. Under the terms of the put option, bank C has the right to sell its investment in entity B back to entity A for C96 million if the market value of its investment falls below C96 million at any time in the next two years.
Entity A has transferred its right to receive cash flows (dividends on the shares) from its investment to bank C. However, in this situation, the investment is transferred, subject to a put option. The result is that the entity neither transfers nor retains substantially all the risks and rewards of ownership of the transferred asset. This is because:
· entity A is still exposed to movements in fair value below C96 million, because if the fair value of the investment falls below C96 million, bank C will put the investment back to entity A for C96 million; and
· entity A has not retained any benefit from increases in the market value of entity B.
Whether entity A has retained control of its investment in entity B will depend on whether bank C has the practical ability to sell the asset in its entirety to an unrelated third party, unilaterally and without imposing additional restrictions on the transfer. In this situation, there is no active market in entity B’s shares, so a 15% stake is not readily obtainable in the market. The put option is neither deeply in-the-money nor deeply out-of-the money (it is slightly out-of-the-money at inception, because the option exercise price of C96 million is less than the market value of the shares at C97 million). However, it is sufficiently valuable to prevent bank C from selling the asset immediately. There would need to be a significant increase in the share’s value to compensate bank C for the premium that it has paid for the put option. These facts, taken together, lead to the conclusion that bank C does not have the practical ability to sell its investment in entity B. Consequently, entity A has retained control, and de-recognition is precluded to the extent of the amount of the asset that is subject to the put option.
Therefore, the entity recognises the investment in entity B at the lower of the fair value of the asset (C97 million) and the option exercise price (C96 million) – that is, C96 million, being the option’s exercise price.
The premium received by entity A for writing the put option is C5 million (consideration received of C102 million less fair value of the asset of C97 million). Because the option is out-of-the-money, the entire premium represents the time value of the option. The associated liability is measured at the option exercise price (C96 million) plus the time value of the option (C5 million) – that is, C101 million. This ensures that the net amount of the transferred asset (C96 million) and the associated liability (C101 million) is equal to the fair value of the put option obligation (C5 million). Therefore, entity A would make the following entries at 1 January 20X6 (date of transfer):
Dr Cr C’m C’m Cash received 102 Investment 1 Liability 101 Suppose that the fair value of the asset decreases to C94 million at 31 December 20X6. The put option is now in-the-money (exercise price of C96 million > C94 million) and its time value is C2 million. The asset is measured at the lower of the asset’s fair value and the option’s exercise price – that is, C94m, the asset’s fair value.
The associated liability is measured at the option’s exercise price (C96 million) plus the time value of the option (C2 million): C98 million. This ensures that the net amount of the transferred asset (C94 million) and the associated liability (C98 million) is equal to the fair value of the put option obligation of C4 million (intrinsic value of C2 million + time value of C2 million). Entity A will record the following entries at 31 December 20X6:
Dr Cr C’m C’m Investment (fall in value from C96m to C94m) 2 Liability (fall in value from C101m to C98m) 3 Other comprehensive income 1 The associated liability should be measured in a manner consistent with the asset in accordance with the general provisions for measuring gains and losses. Therefore, the movement in the liability is also recognised in other comprehensive income. The net gain of C1 million represents the fall in the value of the put option obligation from C5 million to C4 million.
It should be noted that, to the extent that a transfer of a financial asset does not qualify for de-recognition, the transferor’s contractual rights or obligations related to the transfer are not accounted for separately as derivatives. This is because recognising both the derivative and the transferred asset would result in recognising the same rights twice. Therefore, entity A does not recognise the put option separately.
Suppose that the fair value of the asset remains unchanged at 31 December 20X7. Bank C decides to exercise the option, because it is in-the-money. Entity A will have to re-acquire the asset at the put option price. The accounting entries are:
Dr Cr C’m C’m Liability de-recognised 98 Cash paid 96 Other comprehensive income 2 The overall gain of C3 million recognised in other comprehensive income over the two year period represents the difference of C6 million (consideration received of C102 million less amount paid to re-acquire the asset for C96 million) less C3 million (fall in asset value from C97 million at inception to C94 million at exercise). It forms part of the cumulative net gain in other comprehensive income relating to the 15% equity holding in entity B.
Continuing involvement in a part of a financial asset
An entity might have a continuing involvement in only a part of a financial asset rather than the entire asset. This might arise where an entity retains an option to repurchase part of a transferred asset, or retains a residual interest that does not result in the retention of substantially all the risks and rewards of ownership and the entity retains control. The entity allocates the financial asset’s previous carrying amount between the part that it continues to recognise under continuing involvement and the part that it no longer recognises on the basis of the relative fair values of those parts on the date of transfer.
The allocation exercise and the calculation of the gain or loss arising on the part of the asset that is no longer retained are carried out in a similar manner as for servicing assets. The difference between the carrying amount allocated to the part that is no longer recognised and the sum of:
Any cumulative gain or loss that had been recognised in other comprehensive income is allocated between the part that continues to be recognised and the part that is no longer recognised on the basis of the relative fair values of those parts. The recycling of the cumulative gain or loss that had been recognised in other comprehensive income relates to the part no longer recognised of a financial asset that had been recognised at fair value through other comprehensive income.
Continuing involvement in a part of a financial asset
Entity A enters into a securitisation transaction in which it transfers a pool of receivables amounting to C1,000, but it retains a subordinated interest of C100 in that pool.
The terms of the securitisation arrangements show that the transaction is to be accounted for using the continuing involvement approach (which, amongst other things, requires the buyer to assume significant risks and rewards).
Under the continuing involvement approach, the seller typically recognises an asset of C200 and a liability of C100.This gives a net asset of C100, which might be expected, because it represents the retained subordinated interest of C100. However, the gross numbers can be confusing to understand. The transaction comprises:
· a retention of a non-subordinated 10% interest in the transferred assets; and
· the subordination of that interest that is equivalent to the seller providing a credit guarantee.
Both these elements result in continuing involvement and both need to be accounted for. The first element (the retention of a non-subordinated 10% interest) results in a continuing involvement asset of C100. In addition, the second element (the subordination of that interest, which is equivalent to the seller providing a guarantee of the first C100 of losses) also results in a continuing involvement asset of C100, and a liability of C100 (being the maximum amount that the entity might have to pay by losing the C100 asset recognised for the first element). Therefore, the seller will recognise a total continuing involvement asset of C200 and a liability of C100.
Measuring a financial asset in the above manner might not be in accordance with the general measurement rules for financial assets, but it is necessary to ensure that the accounting properly reflects the transferor’s continuing involvement in the asset.
Retained servicing
If a transaction is accounted for using continuing involvement and the transferor is required to service the assets without receiving adequate compensation for the service provided, a servicing liability should be recognised to the extent that the asset is de-recognised. No servicing liability should be recognised to the extent of the continuing involvement asset.
Retained servicing
When accounting for a transaction using continuing involvement, where the transferor is required to service the assets without receiving adequate compensation for the service provided, a servicing liability should be recognised to the extent that the asset is de-recognised. If the asset pretransaction was C100 and the continuing involvement in the asset after the transaction was C60, the transferor would recognise a servicing liability for the C40 de-recognised. It would not recognise a servicing liability for the C60 on the balance sheet.
A transfer of financial assets might require the transferor to provide non-cash collateral to the transferee. Such collateral might include debt or equity instruments. If collateral is transferred to the transferee, the custodial arrangement is commonly referred to as a pledge. Transferees are sometimes permitted to sell or re-pledge (or otherwise transfer) collateral held under a pledge. The accounting for the collateral by the transferor and the transferee depends on whether the transferee has the right to sell or repledge the collateral and on whether the transferor has defaulted as shown in the table below:
Circumstance Accounting by transferor Accounting by transferee Transferee has the right by contract or custom to sell or repledge the collateral. The transferor reclassifies that asset in its balance sheet (for example, as a loaned asset, pledged equity instruments or repurchase receivable) separately from other assets that are not so encumbered. The transferor retains all the risks and rewards of ownership of the asset pledged as collateral and, therefore, cannot derecognise it under the normal rules for de-recognition. The transferee will not recognise the collateral as an asset. If the transferee sells the collateral pledged to it, it recognises the proceeds from the sale and a liability measured at fair value for its obligation to return the collateral. Transferor defaults under the terms of the contract and is no longer entitled to redeem the collateral. Transferor de-recognises the collateral. Transferee recognises the collateral as its own asset initially measured at fair value or, if it has already sold the collateral, derecognises its obligation to return the collateral. The risks and rewards of ownership of the collateral have passed to the transferee. All situations not referred to above.
Transferor continues to recognise the collateral as its asset. Transferee does not recognise the collateral as an asset.
Transferees are required to follow the recognition principles. However, the same asset should not be recognised by both the transferor and transferee at the same time. Therefore, to the extent that a transfer of a financial asset does not qualify for de-recognition by the transferor, the transferee does not recognise the transferred asset as its asset. Instead, the transferee de-recognises the cash or other consideration paid, and it recognises a receivable from the transferor. If the transferor has both a right and an obligation to re-acquire control of the entire transferred asset for a fixed amount (such as under a repurchase agreement), the transferee can account for its receivable as a loan or receivable under IAS 39 or measure it at amortised cost under IFRS 9 if it meets the requirements for such measurement.
The de-recognition rules for financial liabilities are different from those relating to financial assets. A financial liability (trading or other) is removed from the balance sheet when it is extinguished (that is, when the obligation is discharged, cancelled or expires). The guidance on derecognition of financial liabilities, in whole or in part, can be relatively straight forward and less subjective than the guidance for financial assets.
A financial liability (or part of it) is extinguished when the debtor either:
The condition for extinguishment of a financial liability is also met if an entity repurchases a bond that it has previously issued, even if the entity is a market maker or intends to resell it in the near term.
Supplier finance and reverse factoring
Banks might offer services to buyers of goods or services in order to facilitate payments of the trade payables arising from purchases from suppliers. Generally, the supplier delivers goods to the buyer and a trade payable is originated. These are commonly referred to as ‘supplier finance’ or ‘reverse factoring’ arrangements.
In supplier finance and reverse factoring arrangements the buyer selects payables to the supplier that it wishes to be subject to the arrangement and notifies the bank. The supplier receives cash for its trade receivable.
Example 1: Buyer looking to obtain an early payment discount
A buyer would not typically present liabilities payable to a financial institution as trade payables. Trade payables are generally understood to arise in the ordinary course of business with suppliers. When the original liability to a supplier has been extinguished, the resulting new liability to the bank should be presented as bank financing or under another suitable heading rather than ‘trade payables’. If the latter option is taken, the description of the chosen line item needs to be carefully considered to ensure that the entity’s financial position is presented fairly and in a way that faithfully represents the effect of the transaction.
Example 2: Bank negotiates with supplier directly on buyers’ behalf
The bank agrees to pay the supplier before the legal due date to obtain an early payment discount. However, the bank’s payment does not result in the legal settlement of the buyer’s obligation under its trade payable. Rather, the supplier agrees to receive the amount from the buyer net of the early payment discount at the contractual due date and to reimburse the bank this same amount when it receives the payment from the buyer. If the supplier fails to reimburse the bank, the buyer agrees to reimburse the bank. The bank charges a fee to the buyer, which effectively results in the bank and supplier sharing the benefit of the early payment discount. In such a case, since the buyer is not legally released from its original obligation, the buyer continues to recognise the trade payable to the supplier. However, it also recognises a guarantee obligation, initially measured at fair value, for its promise to reimburse the bank if the bank does not receive a reimbursement from the supplier.
Example 3: Receivables purchase agreement
Subsequent to the notification of selected receivables by the supplier, a bank offers the supplier, a receivables purchase agreement. Under this contract, the rights under the trade receivable are acquired from the supplier by the bank, but there is no legal release for the buyer from the payable. It is likely that the buyer will be involved to some extent in such an arrangement. For example, the buyer agrees on changes in his rights under the original terms of the sale of goods. As such, he might no longer be eligible to offset the payable against credit notes received from the supplier, or the buyer might be restricted from making earlier direct payments to the supplier.
The rights of the trade receivable are transferred to the bank, but the buyer’s obligation under the trade receivable is not legally extinguished. In such a case the buyer would need to consider whether the change to the terms of the trade payable is significant. If there is a substantial change, the transfer is accounted for as an extinguishment − that is, the previous liability should be de-recognised and replaced with a new liability to the bank. The effect of any additional restrictions imposed by the reverse factoring agreement on the buyer’s rights will need careful consideration. It might be the case that, because the buyer selects each payable at its sole discretion, it will only select those payables where, from his perspective, the effect of any such restrictions on the rights and obligations is not significant. In contrast, it might be the case that all three (that is, the buyer, bank and supplier) have agreed initially on a minimum amount of payables/receivables being refinanced by the bank. In such cases, the buyer subsequently has no further discretion to avoid the change in his rights, even if the change might be significant to an individual payable.
In-substance defeasance
In-substance defeasance is an arrangement where an entity makes a lump sum payment relating to its obligations to a third party (typically a trust). The trust then applies those funds, and income thereon, to discharge the entity’s obligation to the lender. The entity has little or no right of access to the funds put into the trust. The trust does not assume any legal responsibility for the obligations, and the lender is not a party to the insubstance arrangement.
Some argue that an entity has no right of access to the funds paid to a trust in an in-substance defeasance arrangement, so it has effectively discharged its obligations to the lender. However, this view is inconsistent with the general rule that a liability is not extinguished in the absence of a legal release. Therefore, in-substance defeasance arrangements do not result in de-recognition of the liability.
A debt is extinguished only if the debtor is legally released from its obligation by the creditor. This condition is met even if a creditor releases a debtor from its present obligation to make payments, but the debtor assumes a guarantee obligation to pay if the party assuming primary responsibility defaults. In this situation, the debtor:
Transfer of debt obligation with legal release
Entity A transfers C100 million highly liquid government bonds into a trust that is owned by a registered charity. The trust is not consolidated by entity A. Those bonds will solely be used to repay entity A’s issued C100 million fixed rate liability. The holders of the issued C100 million fixed rate liability have released entity A from its obligation to make payments. However, entity A enters into a guarantee arrangement whereby, if the trust does not make payments when due, it will pay the debt holders.
In this situation, de-recognition of the fixed rate debt instruments is not prevented by virtue of the guarantee. Entity A has obtained legal release, which is a necessary and sufficient condition for the debt’s de-recognition, even though entity A has given a guarantee to a third party.
Entity A (the debtor) recognises a new financial liability based on the fair value of its obligation for the guarantee, and it recognises a gain or loss based on the difference between any proceeds paid and the carrying amount of the original financial liability less the fair value of the new financial liability.
The debtor might pay a third party to assume the obligations under the debt and to obtain legal release from its creditor, instead of providing a guarantee. The debt is then extinguished. However, if the debtor transfers its obligations under a debt to a third party and obtains legal release from the creditor, but undertakes to make payments to the third party so as to enable it to meet its obligation, the debtor recognises a new debt obligation to the third party.
An entity might transfer financial assets (other than cash) that the lender accepts as being in full and final settlement and thereby releases the debtor from its obligations. The entity de-recognises the liability, because the debt has been legally discharged. However, the financial assets transferred might fail the de-recognition criteria, either because the entity has retained substantially all the risks and rewards of ownership or the entity has a continuing involvement in the transferred asset by virtue of retaining control. Therefore, where the de-recognition criteria of the assets used for settlement are not met, the transferred assets are not de-recognised. The entity recognises a new liability relating to the transferred assets.
If a financial liability (or part of a financial liability) is extinguished or transferred to another party, the entity should recognise, in profit or loss, any difference arising between:
Gain on extinguishment of debt in full
A bank has loaned C25 million to a property investment company that invested the funds in residential properties consisting mainly of highquality apartments. However, as a result of a fall in occupancy rates, the entity is unable to meet its debt obligations. The entity successfully negotiated with the bank whereby the bank agreed to accept a property with a fair market value of C20 million in full and final settlement of the C25 million obligation. The property’s carrying value was C21 million.
As a result of the negotiation, the loan is extinguished and the entity recognises a gain on the extinguishment:
C’m Carrying value of liability 25 Fair value of non-cash settlement 20 Gain on extinguishment of debt 5 Carrying value of property 21 Fair value of property transferred 20 Loss on disposal (1) The gain on extinguishment of debt would typically be recorded in the income statement under finance income. The loss on disposal of the property would be charged against operating profits. It would not be appropriate to show a net gain of extinguishment of C4 million in finance income.
The calculation of the gain or loss arising on extinguishment applies, even if the issuer of a debt instrument is a market maker in that instrument or intends to resell it in the near term.
If an entity repurchases only a part of a financial liability, the entity should allocate the previous carrying amount of the financial liability between the part that continues to be recognised and the part that is derecognised. This allocation should be based on the relative fair values of those parts on the date of the repurchase.
The difference between:
De-recognition of part of a liability Consideration paid for a repurchase is not offset against the original liability’s carrying value. Instead, a gain or loss is calculated based on the part de-recognised.
On 1 January 20X5, an entity issued 1 million 8% C100 nominal 10-year term bonds, with interest payable each 30 June and 31 December. The bonds, which are traded in the market, were issued at par. Issue costs of C2 million were incurred. Four years after the issue date, the entity repurchases 600,000 bonds at the then market value of C96 per C100 nominal. The amortised cost of the whole bond at 31 December 20X8 amounted to C98,655,495. The gain arising on repurchase is:
C’m Carrying value allocated to amount repurchased – 60% of C98,655,495 59,193,297 Amount paid on repurchase of 600,000 @ C96 57,600,000 Gain arising on repurchase 1,593,297
An exchange between an existing borrower and lender of debt instruments with substantially different terms should be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) should be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.
Background to exchange and modification of debt instruments
Entities frequently negotiate with lenders to re-structure their existing debt obligations. There might be a variety of reasons for doing so, not necessarily when the entity is in financial difficulties. Such re-structuring might result in a modification or an exchange of debt instruments with the lender, that could be carried out in a number of ways. Examples include:
· An entity might decide to take advantage of falling interest rates by cancelling its exposure to high-interest fixed-rate debt, pay a fee or penalty on cancellation and replace it with debt at a lower interest rate. This is an exchange of old debt with new debt.
· An entity might seek to roll up the higher interest payments into a single payment that is payable on the loan’s redemption. This is a modification.
Whether a modification or exchange of debt instruments represents a settlement of the original debt, or merely a renegotiation of that debt, determines the accounting treatment that should be applied by the borrower.
Change in holders and repayment terms
An entity issued a five-year bond that is listed and traded on a stock exchange. In the following year, the entity proposes a modification of the bond’s repayment terms, to extend the maturity. The proposed modification becomes effective if it achieves approval of more than 75% of the bondholders, in accordance with the terms. The dissenting bondholders are entitled to have their bonds purchased by the entity (or any other party) at fair value, being the market price immediately prior to the proposed modification being presented for the bondholders to consider. The entity appoints an investment bank to stand ready to acquire any bonds from dissenting bondholders. The bank will hold the bonds afterwards as principal. The proposed modification of the repayment terms was accepted by 80% of the bondholders. The dissenting 20% sell their bonds to an investment bank at fair value, and 100% of the bonds are then modified.
The first step is to determine whether the change in holder of 20% of the bonds, from the dissenting bondholders to the investment bank, gives rise to a legal release from primary responsibility for the liability. Depending on the legal jurisdiction, if the change in bondholder results in the legal release from primary responsibility for the original liability, those bonds are extinguished and should be de-recognised. However, in many cases, a change in the holder of a security such as a bond does not result in the entity being legally released from the primary obligation under the liability. The term sheet for a security usually sets out the trading mechanism; in most cases, there is no new contract signed between the issuer and the new holder on a transfer. In these circumstances, the acquisition of the bond by the investment bank from the dissenting bondholders is a transfer of an existing bond, and not the issue of a new bond to a new lender. The transfer is not, therefore, considered to be a change in ‘lender’ before and after the transfer of the bonds.
The second step is to determine whether there has been an exchange or modification between an existing borrower and lender with substantially different terms. As noted above, the transfer of the bonds does not represent a change in the lender. The modification in the bond’s repayment terms is therefore considered to be between an existing borrower and lender for all of the outstanding bonds, rather than merely the 80% that accepted the modification of terms. The entity therefore assesses whether the change in repayment terms amounts to a substantial modification of the terms of an existing liability. Where the change is substantial, it is accounted for as an extinguishment of the original bond and the recognition of a new liability. Where the change in terms is not substantial, it is accounted for as a modification of the original financial liability.
The terms are substantially different if the discounted present value of the cash flows under the new terms, including any fees paid (net of any fees received and discounted using the original effective interest rate), is at least 10% different from the discounted present value of the remaining cash flows of the original financial liability.
Substantially different – qualitative and quantitative tests
f IFRS 9 requires an entity to determine whether the present value of the new cash flows under the new terms is at least 10% different from the present value of the remaining cash flows of the original liability, using the original effective interest rate. If the difference is 10% or greater, the existing liability is de-recognised and a new financial liability is recognised.
The standard is not clear whether the quantitative analysis (described above) is the definition of ‘substantially different’, or whether it is only an example such that a broader analysis that considers qualitative factors can also be performed. We believe that an entity has an accounting policy choice: either it can apply only the quantitative 10% test (described above); or, if the 10% test is passed, it could choose to also perform a qualitative assessment for de-recognition. If the 10% test is failed, however, the existing liability is de-recognised, regardless of whether the entity’s policy is to also perform a qualitative analysis.
The chosen accounting policy should be applied consistently and disclosed.
Qualitative analysis
Determining whether the terms are substantially different, from a qualitative perspective, is judgemental and will depend on the specific facts and circumstances of each case.
Changes to the terms of the liability might be significant, on a qualitative basis, if they significantly affect the economic risks of the liability. Alternatively, the substance of the modification might be that the existing liability is prepaid/settled and a new liability has been issued. Qualitative factors include, but are not limited to, the following:
· A change in the currency in which the liability is denominated.
· A change in the interest basis (such as a change from fixed rate to floating rate, or vice versa).
· A change in any conversion features in the instrument.
· A substantial change in covenants.
· The liability was prepayable at par, with no significant penalty at the date of the renegotiation, which results in the renegotiated rate approximating the current market rate of interest for the new terms and conditions.
· The liability was close to its maturity date at the date of the renegotiation and was extended for a significant additional period, which results in the renegotiated rate approximating the current market rate of interest for the new terms and conditions (including the new maturity date).
Existing borrower or lender – bank syndicates
There is no guidance in the standard that assists in interpreting the terms ‘existing borrower’ and ‘existing lender’ when looking at transactions where lending is via a syndicate of banks. In such cases, the borrower should determine, in the first instance, whether it has borrowed under one loan or under multiple loans. Sometimes, syndicated loans are structured with one ‘lead lender’ signing the loan agreement. The agreement’s substance rather than its legal form should dictate the accounting.
Presented below are a number of factors that, individually or in combination, would tend to indicate that the borrower has borrowed under multiple loans (this is not an exhaustive list): The borrower has the ability to selectively repay amounts on the loan to different members of the syndicate. In other words, any payments made by the borrowers are not always split on a pro rata basis amongst all the syndicate members. The terms of the loan are not homogeneous for various syndicate members. The borrower has the ability to selectively renegotiate portions of the loan with individual syndicate members or subsets of all of the syndicate members. Individual syndicate members have the ability to negotiate their loan directly with the borrower, without the approval of other syndicate members.
Example 1 – Change of loan terms and change in interests within syndicate (single loan)
An entity signs a loan agreement that was negotiated with a syndicate of 20 banks that each have a 5% interest in the total amount borrowed. The entity has determined that it has borrowed under a single loan.
A year later, the borrower and the syndicate members agree to a change in the contract terms that has an impact on future cash flows: an extension of the maturity of the loan. In addition, three banks sell their interest back to one of the existing syndicate members (bank A), so that bank A now has a 20% stake.
From the borrower’s perspective, the loan is a single loan. Accordingly, since the modification is between an existing borrower and lender (the syndicate), the change to the terms of the loan would be evaluated on an aggregate basis to determine whether the modification is an extinguishment. The transfer between syndicate members has no impact on the accounting by the borrower.
Example 2 – Multiple loans
An entity has a loan agreement signed by 20 banks, which are each determined to have granted separate loans to the borrower. Each of the 20 banks has a 5% stake in the total face amount of the loan. If new creditors join the group, they must individually sign a new contract with the borrower. From the borrower’s perspective, these are multiple loans and are accounted for as such.
Four of the banks transfer their 20% combined stake to another bank, without any other change in the terms of the loan. It is necessary to determine whether the transfer is undertaken in a manner that results in the borrower being legally released from primary responsibility for the liability by the existing bank lender. In this example, the new lender has to individually sign a new contract with the borrower, and the borrower is legally released by the existing bank lender. The existing liability is therefore extinguished, and this transaction is accounted for as an extinguishment of the four individual loans by the borrower and the recognition of a new loan liability. The bank to which the 20% stake is being transferred could be one within the original syndicate or one that was not previously a syndicate member.
Bank A (a current syndicate member) might sell a participation in its loan to bank B. In such a case, there would be no effect on the entity (borrower), unless the entity has been legally released from primary responsibility by bank A. Bank A is still a creditor of the entity and bank B is a creditor of bank A.
Alternatively, five of the banks in the syndicate agree to extend the maturity of their loans. The remaining 15 institutions did not agree to the extension. The loans with the banks that agreed to the modification would be evaluated individually, to determine if they were modified or extinguished. The loans to the banks that did not agree to the modification are unchanged. They therefore do not need to be evaluated for modification or extinguishment.
If all of the lenders agree to change terms of the loan that have an impact on its future cash flows, then, in principle, loans with each lender should be evaluated separately to determine if they have been extinguished or modified. If all of the loans have homogeneous terms, practically the same answer will be achieved if the loans are evaluated on an aggregate basis.
Exchange or modification of only one component
The liability being exchanged or modified might be only one component of a financial instrument. Where two or more components of a financial instrument are interdependent, a change to the terms of one component is likely to have repercussions on the others.
Example 1 – Extension of the term of a convertible bond where the conversion option is accounted for as an embedded derivative
Entity B issues a convertible bond in which the conversion option is accounted for as an embedded derivative (because it violates the fixed for fixed rule in IAS 32). Sometime after issuance, the issuer and the holder renegotiate the terms of the convertible bond. The revised terms include extending the bond’s maturity and increasing the conversion ratio: more ordinary shares of the issuer are to be delivered.
From the issuer’s perspective, the modification of the host contract and the derivative should be assessed together when applying the 10% test. This is because the cash flows relating to the host debt and embedded derivative are interdependent.
The term ‘cash flow’ in the 10% test includes the impact of settlement in a variable number of shares. One possible way of applying it is to assess the estimated cash flow as being the higher of:
· the fair value of the share settlement at the date of the modification (using the current market share price); and
· the present value of cash flows attributable to the host.
This approach reflects the optionality, from the holder’s perspective, to choose the more valuable settlement option. Another way of determining the fair value of the share settlement in this approach is to use the forward price(s) of the entity’s shares as at the estimated conversion date, and to discount to the modification date. Where the expected conversion date cannot be estimated reliably under this alternative, the contractual maturity date should be used. Other approaches might also be acceptable.
Example 2 – Exchange of a convertible instrument for debt
Entity A has issued two-year convertible debt for C100, in which the conversion option meets the ‘fixed for fixed’ test in IAS 32. It is therefore accounted for as an equity component, with a liability recognised for the debt component. At the end of year 1, the convertible debt has a fair value of C90 and the host debt component has a fair value of C85. Entity A agrees with the convertible debt holders to exchange their instrument for new non-convertible three-year debt with a fair value of C90. Entity A has a policy choice as to whether a qualitative test is applied in addition to the 10% quantitative test when de-recognising financial liabilities. If entity A considers both qualitative factors and the 10% quantitative test, either of the two approaches (A and B) could be applied, to determine whether the liability component of the convertible bond should be de-recognised. However, if entity A has a policy of only derecognising financial liabilities using the 10% quantitative test, only approach B is applicable.
Approach A – qualitative assessment: extinguished in its entirety
From a qualitative perspective, provided the original conversion option was substantial (that is, its worth is not insignificant to the holder) at the date of the exchange, the new non-convertible debt instrument is substantially different from the convertible debt. This is by virtue of it not being convertible. The risk profile and related returns arising from the original conversion option are effectively terminated. The existing convertible debt should be de-recognised. The new debt should be recognised at its initial fair value of C90. This approach applies the de- recognition rules to the whole instrument (debt and equity components together).
A gain or loss is recognised on the extinguishment of the convertible bond in accordance with IAS 32. This gain or loss is the difference between the carrying amount of the debt component and the allocated consideration paid to redeem it. The full consideration paid (in this case, the C90 new debt issued) is allocated to the debt and equity components of the existing convertible instrument. This is done at the date of the transaction. The allocation is performed using the same method as on initial recognition: by fair valuing the liability, and allocating the residual to the equity component.
The new debt instrument is allocated to the debt and equity components of the convertible instrument using the same method, on an 85:5 basis. The new debt allocated to extinguishing the equity conversion option of C5 (C90 × 5/90) does not result in a gain or loss. Rather, the difference between this amount and the carrying value of the conversion option is taken directly to equity.
Approach B – quantitative assessment: debt component subject to 10% test, equity component extinguished
Under this approach, the de-recognition requirements are viewed as applying to financial liabilities only. Part of the new debt instrument replaces the debt component of the convertible instrument, and part replaces the equity component of the original instrument. The new debt instrument is, therefore, allocated to the debt and equity elements of the convertible instrument for the purpose of their separate de-recognition assessments. The allocation is performed using the same method as on initial recognition. The de-recognition test should be applied to the debt component only. Applying the 10% test on this basis results in the entity continuing to recognise the old debt component. Equally, the terms of the debt component are not considered to be substantially modified, from a qualitative perspective. The revision of the terms of the debt component is, therefore, treated as a modification in this example.
Under IAS 39, where a financial liability measured at amortised cost is modified without this resulting in de-recognition, the difference due to the change in terms (using the same effective rate) is either adjusted for by applying IAS 39, or it is spread over the remaining life of the new debt (for further guidance on accounting for modifications that do not result in de-recognition under IAS 39).
Under IFRS 9, where a financial liability measured at amortised cost is modified without this resulting in de-recognition, a gain or loss should be recognised immediately in profit or loss. This means that the difference cannot be spread over the remaining life of the instrument, which might be a change in practice from IAS 39.
The remaining part of the new debt instrument extinguishes the conversion option, which does not give rise to a gain or loss (IAS 32). The difference between the amount of the new debt that extinguishes the conversion option and the previous carrying value of the conversion option is taken directly to equity.
The combined result of the two elements means that, at the date of the exchange, part of the new debt is measured at its fair value (being the part that replaces the equity component). Where there is no de-recognition of the old debt component, part of the debt is measured at the amortised cost of the old debt component (the part that replaces the debt component of the original convertible).
If applying the de-recognition criteria to the debt component results in derecognition of the existing old debt component, the gain or loss on derecognition is calculated in the same way as discussed under approach A.
Accounting for the restructuring of an undrawn revolving credit facility
Entities with undrawn revolving credit facilities (‘RCFs’) might renegotiate the terms of their borrowing facilities with the existing lender (for example, by extending the maturity or renegotiating the interest rate payable).
Although loan commitments are generally outside the scope of IFRS 9 and IAS 39, they are subject to the de-recognition requirements.
How should an entity apply the ‘10% test’ for financial liabilities (in IFRS 9 IAS 39) in this situation, to determine whether or not the original undrawn RCF has been substantially modified and should be de-recognised, along with any associated deferred fees?
Note that, as well as the quantitative ‘10% test’, an entity might also, as a policy choice, consider qualitative factors.
Under IFRS 9 and IAS 39, the terms are substantially modified if the discounted present value of the cash flows under the new terms, including any fees paid (net of any fees received and discounted using the original effective interest rate), is at least 10% different from the discounted present value of the remaining cash flows of the original financial liability. This is often referred to as the ‘10% test’.
However, judgement is required when applying this test to undrawn RCFs, because there is no explicit guidance in either IFRS 9 or IAS 39 as to how the ‘10% test’ should be applied to undrawn RCFs.
If management is able to reliably estimate the future cash flows of the facility, a reasonable approach could be to use these estimated future cash flows as the basis for the ‘10% test’. If it is not possible to reliably estimate future cash flows, a reasonable approach would be to assume that the facility will be fully drawn. This approach would be consistent with the effective interest method which uses estimated future cash flows through the expected life of the financial instrument if it is possible to reliably estimate these cash flows, and if it is not requires the contractual cash flows over the full contractual term of the financial instrument to be used.
An entity might renegotiate the terms of its debt, with the result that the liability is extinguished by the debtor issuing its own equity instruments to the creditor (referred to as a ‘debt for equity swap’). IFRIC 19 does not apply to transactions with shareholders in their capacity as shareholders or transactions between entities under common control where there is a capital contribution
The issuing entity recognises a gain or loss in profit or loss when a financial liability is settled through the issuance of the entity’s own equity instruments. The new equity instruments are treated as consideration paid for the extinguishment of a financial liability. The amount of the gain or loss recognised in profit or loss is the difference between:
The equity instruments issued are recognised and measured initially at fair value at the date when the financial liability was extinguished.
Gain or loss where settlement is issuance of entity’s own equity instruments
An entity issued a debt instrument amounting to C50 million repayable at par in year 10. Four years after issue, it became clear that the entity was in financial difficulty and was unable to service its existing debt obligations. It therefore reached an agreement whereby the debt holders agreed to accept 5 million equity shares of C1 each in full and final settlement of all amounts due under the debt instrument. The fair value of the equity shares issued in exchange was C25 million.
The new equity instrument is recorded at its fair value of C25 million; and a gain is recognised on the extinguishment of the existing debt instrument. The accounting entries are:
Dr Cr C’m C’m Debt instrument * 50 Equity 25 Profit or loss – gain arising on extinguishment of debt 25 * The debt instrument was measured at C50m at the time of the debt for equity swap.
Background to debt for equity swaps
It is not uncommon for companies to replace their existing debt instruments with equity through renegotiations with their debt holders. This is done in order to reduce excessive interest burden. Debt for equity swaps are mostly carried out by companies that are in financial distress. Debt holders often agree to swap their loans for equity, in the belief, that if they take an equity stake in a troubled company, they will ultimately achieve a greater return.
If the fair value of the equity instruments cannot be reliably measured, the fair value of the existing financial liability is used to measure the gain or loss. In measuring the fair value of a financial liability extinguished that includes a demand feature (for example a demand deposit), IFRS 13 is not applied. Therefore, the fair value of a demand feature can be determined to be less than the amount payable on demand, discounted from the first date when the amount could be required to be repaid.
Only part of the financial liability might be extinguished. The entity must assess whether some of the consideration paid relates to a modification of the terms of the liability that remains outstanding. If part of the consideration paid does relate to a modification of the terms of the remaining part of the liability, the entity allocates the consideration paid. The allocation is between the part of the liability extinguished and the part of the liability that remains outstanding. The entity should consider all relevant facts and circumstances relating to the transaction in making this allocation. The consideration allocated to the remaining liability should form part of the assessment of whether the terms of the remaining liability have been substantially modified. If the remaining liability has been substantially modified, the entity accounts for the modification as an extinguishment of the original liability and the recognition of a new liability at fair value.
Exchange of debt instrument for a modified debt instrument and equity shares
Entity C owes C500 to a lender, which is not a related party, but is unable to pay this liability in full. It renegotiates the debt with the lender. The lender agrees to waive 80% of the liability (C400) in exchange for equity instruments in entity C with a fair value of C200. In addition, the terms of the remaining debt are modified to reset the interest rate and extend the term of the debt. The debt is carried at C500 prior to the renegotiation, and its fair value is C300. The remaining debt has a fair value of C100 after renegotiation. The relative fair values of the instruments after the renegotiation are 33.3% liability (100/300) and 66.7% equity (200/300).
IFRIC 19 applies to 66.7% of the carrying value of the original liability that is extinguished by equity (that is, 66.7% of C500):
Dr Cr C C Liability 333.3 Equity 200.0 Profit or loss 133.3 The remaining 33.3% of the original liability (C166.7) is compared with the new liability, to determine whether there has been a substantial modification of the remaining debt. If there is a substantial modification, additional journal entries are needed to recognise the extinguishment of the remaining debt:
Dr Cr C C Liability (old) 167.7 Liability (new) 100.0 Profit or loss 67.7 Where there is an extinguishment of part of a debt by equity and a substantial modification of the remaining part of the debt, the total gain or loss on extinguishment is equal to the difference between the carrying value of the old liability and the total fair value of the new debt and equity (C500 – C300 = C200).
The amount of the gain or loss should be separately disclosed in the income statement or in the notes.
Transactions involving entities within a group
Transactions between an entity and a lender, where the lender is also a direct or indirect shareholder and is acting in that capacity, are outside the scope of the debtor for equity swap guidance. The guidance also does not apply to transactions where the lender and the entity are controlled by the same party or parties before and after the transaction and the substance of the transaction includes an equity distribution by, or contribution to, the entity. Transactions between entities within the same group should, therefore, be assessed to determine whether they are within or outside of the scope of IFRIC 19.
Transactions involving entities within a group
An entity should assess the facts and circumstances to determine whether a lender is acting in its capacity as shareholder in a transaction – or, for transactions between fellow subsidiaries, whether there is, in substance, a capital contribution or a distribution given (effectively via the parent). This might be the case where the debt for equity swap is structured as a capital contribution. Another example is where the subsidiary is, or subsidiaries are, 100% owned and the number of shares issued is not related to the fair value of the liability. In such a situation, it might not be appropriate to apply IFRIC 19 and recognise a gain or loss in the income statement based on the fair value of the equity instruments issued. Rather, the transaction could be accounted for, either in full or in part, as a capital contribution or distribution. In such circumstances, share capital would be measured as applicable under local law, the liability would be de-recognised, and the difference would be recorded in the equity of the borrower. The remainder of the transaction could then be accounted for in accordance with IFRIC 19.
On the other hand, an entity might determine that the transaction between group companies does not, in substance, include an equity distribution by, or contribution to, the entity. This might be the case where the subsidiary or subsidiaries are not 100% owned, the loan is on commercial terms, and the number of shares issued to the other party is based on the fair value of the liability. In such a case, the subsidiary applies IFRIC 19 and recognises a gain or loss in the income statement for the difference between the carrying amount of the liability and the fair value of the shares.
If an exchange of debt instruments or modification of terms is accounted for as an extinguishment, any costs or fees incurred are recognised as part of the gain or loss on the extinguishment. If the exchange or modification is not accounted for as an extinguishment, any costs or fees incurred adjust the liability’s carrying amount and are amortised over the modified liability’s remaining term.
In a debt modification that does not result in derecognition , what costs or fees are spread forward by adjusting the effective interest rate in accordance with IFRS 9?
Under IFRS 9, costs and fees incurred in modifying a liability are treated differently from changes to the contractual cash flows. It is therefore necessary to distinguish between what is a ‘cost or fee’ of modifying the terms of a liability and what is not.
Consistent with IFRS 9, costs and fees of modifying the terms of the financial liability are spread forward by adjusting the effective interest rate. This applies to costs or fees that the issuer can demonstrate are incremental and directly attributable costs incurred to modify the instrument (such as legal fees for drawing up the amended contract). Conversely, payments that represent compensation for the change in the cash flows of the liability (for example, amounts paid to the lender to compensate it for a change to the coupon to be charged in future periods) should be accounted for in the same way as changes to the cash flows – that is, expensed as part of the gain or loss on modification. Such amounts are not ‘costs or fees’ of modifying the terms, and hence should not be spread forward.
Incremental and directly attributable costs or fees might include amounts paid to third parties, such as lawyers and accountants. Consistent with a proposed amendment to IFRS 9 (proposed as part of the 2018-2020 annual improvements cycle and described in more detail in the next paragraph), some amounts paid directly to the lender might also qualify – for example, if they compensate the lender for similar costs that it pays to third parties. Consistent with IFRS 9, incremental and directly attributable costs or fees do not include debt premiums or discounts, finance costs or internal administrative or holding costs.
This proposed amendment to IFRS 9 addresses which fees should be included in the 10% test. The amendment envisages that costs or fees could be paid to either third parties or the lender. However, the 10% test would include only fees paid or received between the borrower and the lender (including fees paid or received by either the borrower or lender on the other’s behalf). Fees paid to third parties would not be included in the 10% test.
Renegotiation of debt
Where the modification of a financial liability is not accounted for as an extinguishment, the fees paid to third parties are adjusted against the existing liability’s carrying value, together with other payments to the lender. A company borrowed C1 million on 1 January 20X0 at a fixed rate of 9% per annum for 10 years. The company incurred issue costs of C100,000. Interest on the loan is payable yearly in arrears. As a result of deteriorating financial conditions during 20X5, the company approached its bondholders for a modification of the bond’s terms. The following terms were agreed with effect from 1 January 20X6 (all interest paid to date): The interest rate is reduced to 7.5% payable yearly in arrears. The original amount payable on maturity is reduced to C950,000. The maturity of the loan is extended by two years to 31 December 20Y1. Renegotiation fees of C30,000 are payable on 1 January 20X6. The renegotiation fees were paid to the lender, and the entity assessed that they relate to compensation paid to the lender in return for the reduction in interest rate, a reduced final amount payable on maturity, as well as the extension of the term of the loan. The loan would be recorded initially at 1 January 20X0 at net proceeds of C900,000 and would be amortised using the effective interest rate (EIR) method. The EIR is 10.6749%.
Interest Payments Carrying value The proposed amendment to IFRS 9 addresses which fees should be included in the 10% test. The amendment envisages that costs or fees could be paid to either third parties or the lender (although the former would not be included in the 10% test). C C C 10.6749% 1 Jan 20X0 900,000 31 Dec 20X0 96,074 90,000 906,074 31 Dec 20X1 96,723 90,000 912,797 31 Dec 20X2 97,441 90,000 920,238 31 Dec 20X3 98,235 90,000 928,473 31 Dec 20X4 99,114 90,000 937,587 31 Dec 20X5 100,087 90,000 947,674 31 Dec 20X6 101,164 90,000 958,837 31 Dec 20X7 102,355 90,000 971,192 31 Dec 20X8 103,674 90,000 984,866 31 Dec 20X9 105,134 1,090,000 − At 1 January 20X6, the remaining cash flows on the old debt comprise four annual interest payments of C90,000 and the C1 million of principal payable at redemption. The present value of these remaining cash flows on that date amounts to C947,674, as shown above.
The present value of the cash flows under the revised terms discounted at the original EIR of 10.6749%, is:
Cash flows Present value C C 1 Jan 20X6 Fees 30,000 30,000 31 Dec 20X6 Revised interest 75,000 67,766 31 Dec 20X7 Revised interest 75,000 61,230 31 Dec 20X8 Revised interest 75,000 55,324 31 Dec 20X9 Revised interest 75,000 49,988 31 Dec 20Y0 Revised interest 75,000 45,166 31 Dec 20Y1 Revised interest + principal 1,025,000 557,736 867,210 The present value of C867,210 represents 91.5% of the present value of the old cash flows. The difference in present values of C80,464 (947,674 – 867,210) is less than 10% of the present value of the old cash flows. The entity does not apply a qualitative test to the modification of liabilities, and so it performs no further assessment. The modification is not accounted for as an extinguishment. The difference of C80,464 arising from the renegotiation should be recognised immediately in profit or loss by adjusting the previous carrying value of the liability from C947,674 to C867,210 in accordance with IFRS 9.
Under IAS 39, where a financial liability measured at amortised cost is modified without this resulting in de-recognition, the difference due to the change in terms (using the same effective rate) is either adjusted for by applying IAS 39, or it is spread over the remaining life of the new debt.
In a debt modification that results in de-recognition, can any costs or fees be treated as transaction costs and spread forward by adjusting the effective interest rate?
Consistent with IFRS 9, costs and fees are generally accounted for as relating to the extinguishment of the existing instrument, and so they are recognised immediately as part of the gain or loss on that extinguishment. However, only those costs or fees that the issuer can demonstrate are incremental and directly related to the issue of the new debt instrument are treated as transaction costs of the new liability, and hence are spread forward by adjusting the effective interest rate.
Incremental and directly attributable costs or fees might include amounts paid to third parties, such as lawyers and accountants. Consistent with the IFRS IC agenda decision in September 2016, some amounts paid directly to the lender might also qualify – for example, if they compensate the lender for similar costs that it pays to third parties. Consistent with IFRS 9, incremental and directly attributable costs or fees do not include debt premiums or discounts, finance costs or internal administrative or holding costs.
The proposed amendment to IFRS 9 addresses which fees should be included in the 10% test. The amendment envisages that costs or fees could be paid to either third parties or the lender (although the former would not be included in the 10% test).
Transaction costs are also likely to be incurred when an entity extinguishes a liability in exchange for equity instruments. IFRIC 19 does not specify how such costs should be accounted for. However, the issue of equity instruments to extinguish a liability is ‘consideration paid’. IFRIC 19 considers a ‘debt for equity swap’ to be a liability extinguishment in accordance with IAS 39/IFRS 9.
Transaction costs arising in respect of an equity transaction are recognised as a component of equity, to the extent that they are incremental costs directly attributable to the equity transaction that would otherwise have been avoided. Such transaction costs that can be separately identified as relating solely to the issue of the new equity and not to the debt extinguishment should, therefore, be recognised in equity rather than profit or loss.