Pass-through testing

Here are some examples to learn which types of financial instruments/transactions qualify for accounting for a pass-through arrangement. An explanation of a pass-through arrangement and the three conditions a vehicle has to meet in qualifying for a pass-through are provided in ‘Pass-through arrangements‘  If the originator/transferor meets these three conditions the assets transferred are derecognised by the transferor.

Transfer of disproportionate share in pass-through

Question

Can the transfer of a disproportionate share of the cash flows from a loan meet the conditions for a pass-through arrangement?

Background

Entity M originates a five-year interest-bearing loan of 100. M then enters into an agreement with entity N in which, in exchange for a cash payment of 85, M agrees to pass to N the first 90 of all principal and interest payments collected from the loan. M accepts no obligation to make any payments to N other than the first 90 collected. M is prohibited by the terms of the agreement from selling or pledging the loan and has to remit the first 90 of collected cash flows to N without material delay.

Solution

Yes. The transfer of a disproportionate share of cash flows can qualify as a pass-through arrangement. In the above arrangement, the three conditions for a pass-through arrangement are met: M has no obligation to pay cash to N unless it collects the cash from the loan; M has an obligation to pay the cash flows collected from the loan to the eventual recipients (ie, N) without material delay; and M has no right to sell or pledge the transferred asset. Entity M is able to assess whether the entire asset can be derecognised following the remaining steps in the derecognition flow chart, as the arrangement meets the criteria for a transfer.


Revolving structures

Question

Do revolving structures involving a consolidated SPE meet the pass-through requirements in IFRS 9 3.2.5?

Background

An entity sets up a program to sell specified receivables originated over five years to a consolidated SPE. The SPE issues long-term notes to investors. As cash flows are collected on the receivables, those amounts are used by the SPE to purchase new receivables automatically. At the end of five years, collections from the receivables are used to repay the principal of the long-term notes rather than being reinvested in new receivables.

Solution

No. Revolving structures will generally not meet the pass-through requirements. In a revolving structure, an entity collects cash flows on behalf of eventual recipients and uses the amounts collected to purchase new assets instead of remitting the cash to the eventual recipients. On maturity, the principal amount is remitted to the eventual recipients from the cash flows arising from the reinvested assets. Most revolving arrangements involve a material delay before the original collection of cash is remitted. Furthermore, 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.


Material delay

Question

What is meant by ‘without material delay’ in IFRS 9 3.2.5(c)?

Solution

The term ‘without material delay’ is not defined in the standard. Management should therefore exercise judgement in making this assessment. The underlying facts and circumstances should be reviewed carefully to assess whether the time interval between collection of the cash flows and their remittance to eventual recipients is reasonable in relation to the timings of payments on the underlying asset and market practices. If the transfer transaction is a securitisation, generally a period of three months or less is acceptable, as in most securitisations interest is paid on the securitisation finance on a quarterly basis.


Fixed payments and pass-through arrangements

Question

Does an arrangement whereby the transferor pays a fixed amount of cash to the transferee on a monthly basis meet the requirements of a pass-through arrangement?

Background

Manufacturer G 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. G agrees to pay to Bank H every month a predetermined amount of cash equal to the instalments due from its customers in exchange for an upfront cash payment.

Solution

No. Payment of a fixed amount of cash does not qualify as a pass-through arrangement, as it fails the requirements in IFRS 9 3.2.5(a). The amounts G is obliged to pay to H are not dependent on actual cash collections from the office furnishing receivables. G is obliged to pay an amount of cash that has been predetermined at the outset of the contract even if it has not collected the cash from its customers.


Pass-through arrangements

Question

Can an agreement whereby one party assumes a contractual obligation to pay cash flows from a financial asset to another party meet the definition of a pass-through arrangement?

Background

Manufacturer J enters into an arrangement with Factory K. Entity J agrees to pass on the cash flows it collects from specified trade receivables to K for an upfront payment. Entity J has to transfer the collected cash flows within two working days. J has no obligation to transfer cash to K unless it collects equivalent amounts from the trade receivables and is prohibited by the terms of the arrangement with J from selling or pledging the trade receivables to a third party.

Solution

Yes. The three conditions for a pass-through arrangement are met.

  • Entity J retains the contractual rights to receive the cash flows of the financial asset but it assumes an obligation to pass on the cash flows from the underlying assets without material delay.
  • Entity J cannot sell or pledge the asset.
  • Entity J also has no obligation to make payments unless it collects equivalent amounts from the asset.

Entity J now assesses whether the other criteria for derecognition in IFRS 9 are met – ie, it applies the risks and rewards and control tests.


Credit enhancements and pass-through arrangements

Question

Can a credit enhancement in the form of over-collateralisation result in an entity meeting the pass-through requirements?

Background

Entity L sells 10,000 of receivables to a consolidated SPE for an up-front cash payment of 9,000 and a deferred payment of 1,000. The SPE issues notes of 9,000 to investors. Entity L will only receive the deferred payment of 1,000 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 – that is, L suffers the first loss on the transferred assets up to a specified amount.

Solution

Yes. Providing credit enhancement via over-collateralisation may result in an entity meeting the pass-through requirements (provided these requirements are not failed due to other features in the arrangement). If the other pass-through requirements are met, Entity L now assesses whether the other criteria for derecognition in IFRS 9 are met – ie, it applies the risks and rewards and control tests.


Loan sub-participations

Question

Does a loan sub-participation meet the pass-through requirements?

Background

Bank M originates a large loan for a corporate client. M agrees with other banks that in return for an upfront cash payment, it will pass on a percentage of all payments of principal and interest collected on the original loan to the participating banks as soon as they are received from the corporate client. The arrangement is nonrecourse – ie, M has no obligation to pay the other banks unless it collects equivalent amounts from the corporate loan. M also cannot sell or pledge the loan.

Solution

Yes. The three conditions for a pass-through arrangement are met.

  • M retains the contractual rights to receive the cash flows of the financial asset, but it assumes an obligation to pass-on the cash flows from the underlying assets without material delay.
  • M cannot sell or pledge the assets.
  • M also has no obligation to make payments unless it collects equivalent amounts from the asset.

M now assesses whether the other criteria for derecognition in IFRS 9 are met – ie, it applies the risks and rewards and control tests.


Liquidity reserve

Question Pass-through testing

Does a liquidity reserve breach the pass-through requirements in IFRS 9 3.2.5?

Background Pass-through testing

In a securitisation transaction, SPE N (a consolidated subsidiary of the transferor O) is required to maintain a liquidity reserve to enable timely payments to be made to noteholders despite delayed receipts from the original assets. O has pre-funded this reserve when establishing N.

Solution Pass-through testing

Yes. Establishing a pre-funded liquidity reserve, results in an obligation to pay amounts to eventual recipients that were not collected from the original asset ( IFRS 9 3.2.5(a)).


Funding commitment

Question Pass-through testing

Does a funding commitment, breach the pass-through requirements in IFRS 9 3.2.5?

Background Pass-through testing

In a securitisation transaction, SPE P (a consolidated subsidiary of the transferor Q) may be required to provide a liquidity facility to enable timely payments to be made to noteholders despite delayed receipts from the original assets. Transferor Q has provided a commitment to advance cash to P when required (which can be recovered only via retention of future cash flows from the original transferred assets).

Solution Pass-through testing

Yes. A commitment by the transferor to provide funding subsequently results in an obligation to pay amounts to eventual recipients that were not collected from the original asset ( IFRS 9 3.2.5(a)). Amounts paid do not represent allowable short-term advances, as there is no right of recovery in the event of insufficient cash flows from the original asset.


Reserve fund from excess cash

Question Pass-through testing

Does a reserve fund created from excess cash breach the requirements in IFRS 9 3.2.5 (a) and (c)?

Background Pass-through testing

In a securitisation transaction, SPE R established a reserve fund created out of ‘excess’ cash flows collected from the transferred assets over and above those required to pay noteholders. It is contractually specified which cash flows are considered to be ‘excess’ cash flows. When the notes issued by R are fully repaid at the end of the arrangement, the transferor is entitled to the remaining balance of the reserve fund.

Solution Pass-through testing

No. First, for IFRS 9 3.2.5(a), the transferor is not paying the eventual recipients any amounts other than those collected from the original asset because the fund is created through the cash flows from the transferred assets. Second, for IFRS 9 3.2.5 (c), any amounts due to the transferor that are held in this reserve fund are not ‘collected on behalf of eventual recipients’ and therefore not subject to the ‘material delay’ requirement.

The purpose of setting up the fund is to make sure the cash is passed to eventual recipients without material delay once amounts become due to those eventual recipients. The risks and rewards analysis should then be applied to the transferred assets in their entirety.

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