Derecognition of financial assets

Derecognition of financial assets has drawn a lot of attention in the Enron scandal. Enron used special purpose entities—limited partnerships or companies created to fulfil a temporary or specific purpose to fund or manage risks associated with specific (financial and/or non-financial) assets. Derecognition of financial assets

On October 16, 2001, Enron announced that restatements to its financial statements for years 1997 to 2000 were necessary to correct accounting violations. The restatements for the period reduced earnings by $613 million (or 23% of reported profits during the period), increased liabilities at the end of 2000 by $628 million (6% of reported liabilities and 5.5% of reported equity), and reduced equity at the end of 2000 by $1.2 billion (10% of reported equity). Derecognition of financial assets

So doing it right is important!

A financial asset is derecognised only when the contractual rights to the cash flows from the financial asset expire or when the financial asset is transferred and the transfer meets certain specified conditions (‘the asset transfer test’). Derecognition of financial assets

An entity derecognises a transferred financial asset if it transfers substantially all of the risks and rewards of ownership (‘the risks and reward test‘). An entity does not derecognise a transferred financial asset if it retains substantially all of the risks and rewards of ownership.

A financial asset is derecognised only when the contractual rights to the cash flows from the financial asset expire or when the financial asset is transferred and the transfer meets certain specified conditions: Derecognition of financial assets

• An entity derecognises a transferred financial asset if it transfers substantially all of the risks and rewards of ownership. An entity does not derecognise a transferred financial asset if it retains substantially all of the risks and rewards of ownership.
• An entity continues to recognise a transferred financial asset to the extent of its continuing involvement if it has neither retained nor transferred substantially all of the risks and rewards of ownership, and it has retained control of the financial asset.

[IFRS 9 3.2, IFRS 9 B3.2.1] Derecognition of financial assets

Introduction

A financial asset (or part of a financial asset) is derecognised when: The rights to the cash flows from the asset expire. The rights to the cash flows from the asset and substantially all risks and rewards of ownership of the asset are transferred. An obligation to transfer the cash flows from the asset is assumed and substantially all risks and rewards are transferred. Substantially all the risks and rewards are neither transferred nor retained but control of the asset is transferred. If the entity retains control of the asset but does not retain or transfer substantially all the risks and rewards, the asset is recognised to the extent of the entity’s continuing involvement. A financial liability is removed from the balance sheet only when it is extinguished – that is, when the obligation specified in the contract is discharged or cancelled – or expires. A transaction is accounted for as a collateralised borrowing if the transfer does not satisfy the conditions for derecognition.

Derecognition of financial assets

In many cases it is not difficult to assess whether or not a financial asset is derecognised. For example, when a manufacturer receives a payment from a customer for the delivery of spare parts, the manufacturer no longer has any rights to further cash flows from the receivable and should remove it from the balance sheet.

Where a company sells a portfolio of trade receivables or mortgages in order to receive finance, it is less obvious whether those financial assets should be derecognised. Examples of such arrangements are debt factoring and securitisation schemes.

The following flow chart summarises the criteria for derecognition in IFRS 9 (IFRS 9B.3.2.1)

Decision tool

Here is the decision tool framed in a tool to walk through the decision tree regarding the evaluation of whether and to what extent a financial asset is derecognised as per IFRS 9 B3.2.1.

IFRS 9 Derecognition tree Step 1 Consolidate

Step 1 is to look at the consolidated level (a sale between consolidated subsidiaries or the parent company and a subsidiary is no sale on a consolidated basis. [IFRS 9 3.2.1]

Background

Many derecognition structures use entities (for example, trusts and partnerships) that have been specifically set up for the acquisition of the transferred assets. The transfer of assets to such an entity might qualify as a legal sale. However, if the relationship between the transferor and the
transferee suggests that the transferor controls the transferee, the transferor needs to consolidate the transferee.

The derecognition principles therefore have to be applied on a consolidated level.

IFRS 9 Derecognition Step 1 Consolidate Action

The first step is to determine what is the reporting entity that is considering whether to derecognise the financial asset – that is, whether it is the consolidated or the individual entity. If it is the consolidated entity, the entity should first consolidate all subsidiaries, including any special purpose entities (SPEs), in accordance with IFRS 10 Consolidated Financial Statements. Then the derecognition analysis is applied to the resulting group.

As most complex financing transactions incorporate a number of SPEs, this step is fundamental to understanding the nature of the transaction and the consequential accounting. For example, there may be a legal sale from the entity into a trust (SPE), but if the entity has control of the trust, the analysis of the transaction from the perspective of the consolidated group may be that there is no sale for accounting purposes under IFRS 9.

A variety of factors need to be evaluated to determine the substance of the arrangement between an entity and an SPE and whether control is present such that the SPE is consolidated. Indicators of control provided in IFRS 9 are: Derecognition of financial assets

• the SPE conducts its activities on behalf of the reporting entity; Derecognition of financial assets
• the reporting entity has the decision-making power; Derecognition of financial assets
• the reporting entity can obtain the majority of the benefits of the SPE; or Derecognition of financial assets
• the reporting entity has the majority of the residual or ownership risks of the SPE or of its assets. Derecognition of financial assets

The decision to consolidate an SPE is always dependent on specific facts and circumstances; if those change, entities will need to re-assess their consolidation decisions. This is especially relevant when companies are stepping in to support SPEs when there was previously no contractual relationship to do so. Derecognition of financial assets

If the individual entity is the reporting entity that is considering whether to derecognise the financial asset step 1 can be skipped (but that also needs to be documented).

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IFRS 9 Derecognition tree Step 2 Part or all assets

The second step is to determine whether the derecognition principles in the following decision tree are applied to a part or all of an asset (or group of similar assets) [IFRS 9 3.2.2]

IFRS 9 Derecognition Step 2 Part or all assets

Step 2  is to 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 the financial asset in its entirety (or a group of similar financial assets in their entirety). The derecognition requirements should be applied to a part of a financial asset (or part of a group of similar financial assets) only if the part being considered for derecognition meets one of the following three conditions:

• The part comprises only specifically identified cash flows from a financial asset (or a group of similar financial assets). For example, if an entity enters into an interest rate strip whereby the counterparty obtains the right to the interest cash flows, but not the principal cash flows from a debt instrument, the derecognition requirements are applied to only the interest cash flows.
• The part comprises only a fully proportionate (pro-rata) share of the cash flows from a financial asset (or a group of similar financial assets). For example, if an entity enters into an arrangement in which the counterparty obtains the rights to a 90% share of all cash flows of a debt instrument, the derecognition requirements are applied to that 90% of the cash flows. If the rights to 90% of the cash flows of an asset of C100 are transferred and only C90 is recovered, the transferee receives C81 and not C90.
• The part comprises only a fully proportionate (pro-rata) share of specifically identified cash flows from a financial asset (or a group of similar financial assets). For example, 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 derecognition requirements are applied to that 90% of the interest cash flows.

The above criteria should be applied strictly to determine whether the derecognition requirements should be applied to the whole asset or to only a part of the asset. If none of the above criteria is met, the derecognition requirements are applied to the financial asset in its entirety (or to the entire group of similar financial assets).

Once it has been established whether the derecognition requirements should be applied to the whole asset (or the whole of a group of similar assets) or to a qualifying part or portion identified in step 2, the remaining steps are applied to the whole or part identified. This is referred to as ‘the financial asset’ in the steps below [IFRS 9 3.2.2].

Example 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, but provides a guarantee to compensate the buyer for any credit losses up to 8% of the principal amount of the receivables. In this case, although the transferor has transferred 90% of all cash flows from the asset, the existence of the guarantee means the transferor has an obligation that could involve it in repaying some of the consideration received. Therefore, the derecognition requirements must be applied to the asset in its entirety and not just to the proportion of the cash flow transferred.

Example 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 (interest and principal) arising in the last 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. In other words, the entity retains the right to interest cash flows for the first six years. In this situation, it is clear that the entity has transferred the rights to the last 4 years of cash flows that represent specifically identifiable cash flows (the last 4 years of interest cash flows + principal cash flows). Therefore, in accordance with IFRS 9 3.2.2, the derecognition rules should be applied to this identifiable portion.

IFRS 9 Derecognition tree Step 2 Rights to cash flow expired

Now the first decision has to be made:

Step 3 Have the rights to the cash flows from the asset expired? [IFRS 9 3.2.3(a)]

Once the entity has determined at what level (entity or consolidated) it is applying the derecognition requirements and to what identified asset (individual, group or component) those requirements should apply, it can start assessing whether derecognition of the asset is appropriate.

Step 3 considers whether the contractual rights to the financial asset have expired. If the contractual rights to the cash flows from a financial asset (or part of the asset) have expired or are forfeited, the entity derecognises the financial asset.

This is the case when a debtor discharges its obligation by paying the holder of the financial asset or when the debtor’s obligations to the holder have ceased (for example, when the rights under an option expire).

Other instances

Other less obvious instances of expiration are:

Renegotiation and modification of a financial asset

Some modifications of contractual cash flows will result in derecognition of a financial instrument and the recognition of a new financial instrument in accordance with IFRS 9. The derecognition criteria in the context of renegotiations and modifications of contractual terms are set out quite well for financial liabilities, but not so for financial assets. IFRIC tried to tackle the lack of specific requirements but ultimately decided that it could not resolve it in an efficient manner and not to further consider such a project (May 2016 IFRIC update).

A useful discussion is contained in May 2012 and September 2012 IFRIC updates in the context of the restructuring of Greek government bonds in the aftermath of 2007/2008 financial crisis. IFRIC concluded that, in determining whether a debt restructuring results in the derecognition of the financial asset, the best approach is to make an analogy (based on IAS 8 hierarchy) to derecognition criteria for financial liabilities referring to an exchange between an existing borrower and lender of debt instruments with substantially different terms.

A sure thing is that even if a renegotiated asset is not derecognised, a one–off modification gain/loss should still be recognised.

Write-offs

Write-offs of financial assets for IFRS 9 can relate to a financial asset in its entirety or to a portion of it. For example, an entity plans to enforce the collateral on a financial asset and expects to recover no more than 30 per cent of the financial asset from the collateral. If the entity has no reasonable prospects of recovering any further cash flows from the financial asset, it should write off the remaining 70 per cent of the financial asset (IFRS 9 5.4.4;IFRS 9 B5.4.9).

However, derecognition at this step is generally obvious and requires little or no analysis [IFRS 9 3.2.3].

Take care: The sale of a financial asset does not fall under this step, as the contractual rights to cash flows from the asset continue to exist even if the seller no longer has the rights to them. The seller would therefore need to consider the steps further down the flowchart.

THE QUESTION in STEP 3

Have the rights to the cash flows from the asset expired?

Yes | No

Continue using this decision tree to evaluate whether and to what extent a financial asset is derecognised…. Document the IFRS questions (including IFRS references) and your answers and your derecognition file is ready for review and authorisation.

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Links for more on each IFRS referenced in the decision tree: IFRS 9 3.2.3(a) Rights to cash flows expired, IFRS 9 3.2.4(a) Transferred rights, IFRS 9 3.2.4(b) Assumed an obligation, IFRS 9 3.2.6(a) Transfer risk and rewards test,  IFRS 9 3.2.6(b) Retained risks and rewards test,  IFRS 9 3.2.6(c) Retained control, IFRS 9 B 3.2.13 Continuing involvement

Also read: IFRS Community – Derecognition

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