This is an illustration of how derecognition is applied in practice. The objective is to present the mechanics of applying the IFRS 9 requirements for derecognition of financial assets, starting with an analysis of the transaction using the flowchart [IFRS 9 B3.2.1], and culminating with the initial and subsequent accounting entries for both the transferor and transferee.
Background and assumptions
Entity P has originated a group of similar five-year fixed rate corporate loans for €9,980,000 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, P assigns the loans to a third-party bank for €10.1 million but 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 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, as interest is charged on late payments.
Note that continuing involvement is a unique accounting model for which little guidance is provided in IFRS 9. There may therefore be other acceptable ways to account for the following transaction.
- Fair value of loans €10 million (fair value = book value, originated for €9,980,000, so the fair value has increased by €20,000 since origination)
- Fair value of guarantee obligation €100,000
- Fair value of guarantee fee €57,000 (PV of 13bp fee on OPB)
- 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 flowchart [IFRS 9 B3.2.1]
Step 1 Consolidate all subsidiaries
There are no SPEs involved. P has sold the loans directly to the bank.
Step 2 Determine whether the derecognition 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 may 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, 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 meeting the definition of a transfer, as 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
P has retained one-third of any credit losses that are incurred by the bank on these loans. P has not retained any other risk on these loans. Therefore, P has retained some risks and rewards, as 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, as 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 P still controls the loans. Therefore, P will continue to recognise the loans to the extent of its continuing involvement.
P has neither retained nor transferred substantially all 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 €10 million.
- The maximum amount of the consideration received (€10.1 million) that the entity could be required to repay – the guaranteed amount – is one-third of the principal balance and amounts to €3,333,333.
The continuing involvement asset is therefore €3,333,333 (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, as per IFRS 9 3.2.17(b).
The entity has the obligation to provide a guarantee for one-third of credit losses. The fair value of the guarantee obligation is €100,000. Accordingly, the liability is 33,433,333, being the aggregate of the amount of the continuing involvement asset above (€3,333,333) and the guarantee (€100,000).
Accounting entries on origination of the loans
To record the cash lent at origination of the loan.
Accounting entries just before transfer, as fair value of loans has increased
Profit or loss
To record the cash lent at origination of the loan.
Accounting entries on date of the transfer
Cash Sale of loans – guarantee retained
Loans Sale of loans – guarantee retained
To record the cash received on the sale of the loans
Continuing involvement asset Sale of loans – guarantee retained
(inclusive of the guarantee receivable of 57,000)
Continuing involvement liability Sale of loans – guarantee retained
(inclusive of the guarantee liability of 100,000)
To record P’s continuing involvement in the loans resulting from the guarantee.
For illustration purposes, we have shown a credit to loans of €10 million and a debit of €3,333,333 for the new continuing involvement asset. In practice, these entries would be combined, as 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, as the assets were already carried at fair value.
Subsequently, the continuing involvement asset will continue to be measured at fair value through profit or loss. To the extent there is an expected payout 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, as amounts are collected on the loans, both the continuing involvement asset and liability are similarly reduced.
Assume we are one year later, and the fair value of the loans has decreased by €384,000, of which we still have continuing involvement in one-third, and the fair value of the guarantee is now €174,000.
(in €) Sale of loans – guarantee retained
Continuing involvement assets (reflecting the change in fair value of assets) (one-third of 384,000)
Continuing involvement liability (reflecting the change in fair value of assets and increase in fair value of guarantee 128,000-74,000)
Net profit and loss Sale of loans – guarantee retained
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 asses two transfers of proportions of the asset for derecognition – one without recourse (67% of the asset) and one with recourse (33% of the asset), which would achieve similar accounting in this example.