The best 1 – Risk and Rewards Test and Control Test

Risk and Rewards Test and Control Test are, in combination, used to validate the accounting for a transfer of a financial asset under IFRS 9 Financial instruments. Based on criteria in previous steps it has been concluded that an entity has transferred a financial asset using the following decision tree (see IFRS 9 B3.2.1): Risk and Rewards Test and Control Test

Risk and Rewards Test and Control Test

 

The central questions here are: Risk and Rewards Test and Control Test

1) has the entity transferred or retained substantially all risks and rewards (the ‘Risk and rewards test’)?

and Risk and Rewards Test and Control Test

2) has the entity retained control of the asset(s) (the ‘Control test’)? 

Which leads to 3 possible outcomes, or in a diagram: Risk and Rewards Test and Control Test

Risk and Rewards Test and Control Test

The risk and rewards test

These steps in the risk and rewards test are set out in paragraphs IFRS 9 3.2.6(a)-(b). The three potential outcomes of this evaluation are (see diagram above):

  1. transfer of substantially all risks and rewards of ownership (what normally would be called a (true) sale), derecognise the asset. If there are any rights and obligations created or retained in the transfer, they should be recognised separately as assets or liabilities (IFRS 9 3.2.6(a)],
  2. retain substantially all risks and rewards of ownership (what could be a lease or a rent contract), continue to recognise the asset [IFRS 9 3.2.6(b)], and Risk and Rewards Test and Control Test
  3. the more difficult outcome in between of 1. and 2 – transferred some. [IFRS 9 3.2.6(c)]

1. + 2. Often it will be obvious whether the entity has transferred or retained substantially all risks and rewards of ownership and there will be no need to perform any computations. Risk and Rewards Test and Control Test

3. In other cases, it will be necessary to compute and compare the entity’s exposure to the variability in the present value of the future net cash flows before and after the transfer. Computations and comparison are made using an appropriate current market interest rate as the discount rate. All reasonably possible variability in net cash flows is considered, with greater weight being given to those outcomes that are more likely to occur [IFRS 9 3.2.7-8]. Risk and Rewards Test and Control Test

IFRS 9 does not set any threshold that would represent ‘substantially’ all risks and rewards.

Examples of when an entity has transferred substantially all the risks and rewards of ownership are given in paragraph IFRS 9 B3.2.4 and examples of when an entity has retained substantially all the risks and rewards of ownership are given in paragraph IFRS 9 B3.2.5. Finally, an example of when an entity has neither retained nor transferred substantially all the risks and rewards is given in paragraphs IFRS 9 B3.2.16(h)-(i) and IFRS 9 B3.2.17.

The control test

The control test step is the last test to be conducted in the derecognition decision tree (see  IFRS 9 B3.2.1). It should be answered when an entity transferred an asset, but has neither retained nor transferred substantially all risks and rewards. If the entity has not retained control, it should derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.

If the entity has retained control, it continues to recognise the financial asset to the extent of its continuing involvement in the financial asset (IFRS 9.3.2.6(c)).

Whether the entity has retained control of the transferred asset depends on the transferee’s (i.e. a party to whom the asset was transferred) ability to sell the asset. If the transferee has the practical ability to sell the asset in its entirety to an unrelated third party and is able to exercise that ability unilaterally and without needing to impose additional restrictions on the transfer, the entity has not retained control. In all other cases, the entity has retained control (IFRS 9 3.2.9). Risk and Rewards Test and Control Test

Paragraphs IFRS 9 B3.2.7-9 elaborate on what is meant by practical ability to sell the asset. It starts with a sentence saying that ‘transferee has the practical ability to sell the transferred asset if it is traded in an active market because the transferee could repurchase the transferred asset in the market if it needs to return the asset to the entity’. Some tend to interpret this as a condition that an asset must be traded in an active market irrespective of the circumstances. Risk and Rewards Test and Control Test

The general opinion is that this is not the case, as the explanation goes on to say that an active market is needed when the transferee would need to repurchase the transferred asset in the market if it needs to return the asset to the entity. If the transferee would not be obliged to repurchase a transferred asset under no circumstances, there need not be an active market in order to conclude that the control has been transferred.

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In any case, accounting consequence will often be essentially the same, as retaining control means accounting for continuing involvement in the asset (see below), which will often be similar to recognition of any assets or liabilities resulting from rights and obligations created or retained in the transfer under paragraph IFRS 9 3.2.6(c).

IFRS 9 Continuing involvement

Under the IFRS 9 continuing involvement approach, the entity continues to recognise part of the asset. The amount of the asset that continues to be recognised is the maximum amount of the entity’s exposure to that particular asset or its previous carrying amount, if lower. The presentation of the asset and liability will result in the recognition of the entity’s remaining exposure on the balance sheet on a gross basis (ie, both an asset and a liability).

The asset will be measured either at fair value if the asset was previously held at fair value, or at amortised cost if the asset was previously accounted for on that basis. The treatment of the changes in the liability should be consistent with the treatment of changes in the asset. Consequently, when the transferred asset is classified as available for sale, gains and losses on both the asset and the liability are taken to equity.

Where a guarantee causes the IFRS 9 continuing involvement, the asset recognised at the date of transfer is measured at the lower of the carrying amount of the asset and the maximum amount of the consideration received in the transfer that the entity could be required to repay (the guaranteed amount).

As the net amount of the asset and associated liability represents the fair value of the guarantee, the associated liability is the balancing number. The liability is initially measured at the guarantee amount plus the fair value of the guarantee (which is normally the consideration received for the guarantee). The diagram below provides an overview.

Continuing involvement Transfer of financial assets

The component of the liability attributable to the guarantee is subsequently recognised in profit or loss on a systematic basis in the same way as any other guarantee fee is amortised under IAS 18, to the extent that the asset was previously measured at amortised cost, or remeasured to fair value if the asset was previously at fair value.

Repayments on the underlying assets are reflected by a reduction in the carrying amount of both the asset and the liability. For assets previously measured at amortised cost, any impairment in the recoverability of the asset is accounted for as normal under IAS 39, with no adjustment to the carrying amount of the liability.

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Where a written put option is the cause of the IFRS 9 continuing involvement, and the asset was previously measured at fair value, the transferred asset is measured at the lower of fair value and the option’s strike price, as the entity has no exposure to increases in fair value above the strike price (ie, the maximum amount it continues to be exposed to is the lower of the strike price or fair value).

As the net amount of the asset and associated liability has to be the fair value of the option, the associated liability is the balancing number. It is initially measured at the option strike price plus the time value of the option.

Continuing involvement Put option

Subsequently, any changes in the fair value of the transferred asset and associated liability are accounted for consistently such that at all times the net amount is the fair value of the option. For example, if the asset was previously classified as an AFS equity investment, any changes in the fair value of the transferred asset and associated liability (other than impairments) are recognised in a separate component of equity.

Where a purchased call option is the cause of the continuing involvement and the asset was previously measured at fair value, the transferred asset continues to be measured at fair value. The net amount of the asset and associated liability is always the fair value of the option. The associated liability is the balancing number and is measured initially at (a) the lower of the fair value of the transferred asset or the strike price less (b) the time
value of the option.

Where the asset was previously measured at amortised cost, the asset continues to be measured at amortised cost, and the liability is measured at the consideration received (cost). The liability is subsequently adjusted for the amortisation of any difference between its initial cost and the carrying value of the transferred asset at the expiration date of the option.

If the option is exercised, any difference between the carrying amount of the associated liability and the exercise price is recognised in profit or loss.

IFRS 9 Continuing involvement

Subsequently, any changes in the fair value of the transferred asset and associated liability are accounted for consistently with each other.

Food for thought

If a written put option or a purchased call option prevents a transferred asset from being derecognised and the transferred asset was previously measured at amortised cost, the associated liability is measured at its cost (ie, the consideration received) adjusted for the amortisation of any difference between that cost and the amortised cost of the transferred asset at the date of expiry of the option.

For example:

  • the transferor sells an amortised cost asset and writes a put to the transferee for C95.
  • The amortised cost of the asset on the date of transfer is C98.
  • The amortised cost of the asset on the expiration of the option will be C100.
  • The fair value of the asset on the date of the transfer is C92.
  • The exercise price of the written put is C90 and therefore the premium received for writing the option consists entirely of time value, being C3.

In this case, the accounting is as follows:

  • The asset will continue to be recognised at C98.
  • The associated liability will be recognised at the consideration received, C92.
  • The difference between the C95 and C100 is recognised in profit or loss using the effective interest method.
  • If the option is exercised, any difference between the carrying amount of the associated liability  and the exercise price is recognised in profit or loss.
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Servicing assets and liabilities

If an entity transfers a financial asset that qualifies for derecognition and retains the right to service it for a fee, it recognises either a servicing asset or a servicing liability for the servicing contract that is initially measured at fair value. A liability for the servicing obligation is recognised if the fee to be received is not expected to compensate the entity adequately for performing the servicing.

An asset is recognised for the servicing contract if the fee to be received is expected to be more than adequate compensation for the servicing. Adequate compensation is determined by benchmarking what a normal market servicer would earn for providing the servicing. Subsequently, servicing assets or liabilities are amortised rateably over the service period.

No derecognition (on balance sheet)

A transaction is accounted for as a collateralised borrowing if the transfer does not satisfy the conditions for derecognition. The entity recognises a financial liability for the consideration received for the transferred asset. If the transferee has the right to sell or repledge the asset, it is presented separately in the balance sheet (for example, as a loaned asset, pledged security or repurchased receivable).

In subsequent periods, the entity recognises income relating to the transferred assets and any expense incurred on the financial liability. Where a derivative forms part of the transaction and precludes the asset from being derecognised, the derivative is not accounted for separately, as this would result in the derivative being accounted for twice.

Full derecognition with (potential) recognition of new assets or liabilities retained

When an entity has neither transferred nor retained substantially all the risks and rewards but has transferred control, it derecognises the financial asset and recognises separately as assets or liabilities any rights and obligations created or retained in the transfer.

For example, if an entity sells an asset that is traded in an active market but retains a call option to buy back that asset at a fixed price, the transferor derecognises the asset and recognises the call option.

Accounting by Transferee

The transferee cannot account for an asset that the transferor was not able to derecognise and vice versa. It is therefore important for a transferee to assess whether IFRS would require the transferor to derecognise the asset.

Full derecognition for the transferor

If a transfer of a financial asset qualifies for derecognition, the transferee recognises the asset as its own and classifies it according to the criteria in IFRS 9. In addition, it will derecognise the cash or other consideration it paid for that asset.

No derecognition for the transferor

To the extent that a transfer of a financial asset does not qualify for derecognition, the transferee does not recognise the transferred asset as its asset. The transferee derecognises the cash or other consideration paid and recognises a receivable from the transferor.

If the transferor has both a right and an obligation to reacquire the entire transferred asset for a fixed amount (such as under a repurchase agreement), the transferee may account for its receivable as a loan or receivable in IFRS 9. In other cases, available for sale would be the most likely classification.

Also read: Derecognition

Risk and Rewards Test and Control Test

Risk and Rewards Test and Control Test IFRS 9 Continuing involvement Accounting by Transferee The control test The risk and rewards test

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