Accounting for Securitisation Transactions Under IAS 39
In December 2003, the International Accounting Standards Board (IASB) published revised versions of International Accounting Standards 32 (IAS 32) and 39 (IAS 39) together with an implementation guidance paper. Since the IASB does not intend to issue any further consultation papers and is not inviting any further comment, the new standards will, barring unforeseen developments become effective from 1 January 2005 (the ‘Effective Date’). UK companies familiar with Financial Reporting Standard 5 (FRS 5) will need to take note of the difference in approach proposed by IAS 39. In particular, as from the Effective Date, linked presentation treatment provided for pursuant to FRS 5 will no longer be available for securitisation transactions and will be replaced with the new derecognition/continuing involvement regime set out in IAS 39.
In addition, save in relation to certain specified exceptions (see paragraphs 105-108 of IAS 39), it is not proposed to ‘grandfather’ existing transactions previously reported in accordance with FRS 5. Rather, IAS 39 will apply retrospectively. In other words, UK originators that have entered into transactions which remain current/outstanding after the Effective Date will, as from that date, be required to report the transactions in their accounts in accordance with the rules set out in IAS 39.
What follows is a very brief summary of the main provisions of IAS 39 and is not an exhaustive analysis of the new standards contained in IAS 32 and IAS 39. In dealing with all types of financial instrument, together with the disclosure and presentation requirements and principles for recognition and measurement of all such instruments, including new rules for hedge accounting, the standards go beyond the scope of this article. The news is not all bad. In 2002, the IASB published an exposure draft of proposed amendments to IAS 32 and IAS 39 which introduced some extraordinary new recognition and disclosure concepts based on the newly defined accounting reference term of ‘continuing involvement’. Under that proposal, companies would have had to separate out numerous component elements of a complex financial transaction and account for each of them, including requirements to value and report items such as ‘servicing assets’ and ‘servicing liabilities’.
The welcome news is that this approach has largely been abandoned by the IASB, although the ‘continuing involvement’ concept is still of some relevance, in particular to securitisation transactions which are likely to fall into the category of reporting proposed for entities transferring assets whilst retaining some control or interest in such assets.
The new standards have been issued as three papers: IAS 32 deals with the disclosure and presentation treatment for financial instruments and also sets out the important definitions which are necessary for applying the standards, the most relevant definition for present purposes being what constitutes a ‘financial asset’. Each of the standards contains Application Guidance paragraphs (AG) as well as Basis for Conclusions (BC) paragraphs, which illustrate the methods used by the standards and also set them in context. Given the list of examples provided (in IAS 32, AG4), it is likely that most, if not all, assets the subject of a proposed securitisation transaction will fall within this definition. The implementation guidance paper to IAS 39 offers an extensive list of detailed definitions/examples of each type of financial instrument and their treatment and measurement, but the main principles of application are set out in IAS 39 itself. Amongst other new accounting rules, IAS 39 deals comprehensively with the principles underlying recognition and derecognition of asset transfers, specific rules for hedge accounting and rules relating to the way in which assets are measured/valued. Of primary relevance for present purposes, paragraphs 17-23 of IAS 39 contain the primary rules as to when transfers of financial assets by a reporting entity should be derecognised.
The first important point to note is that the new standards retain the requirement for consolidation which was the subject of a significant amount of comment when it was first proposed. Thus a reporting entity will first need to consolidate all its ‘subsidiaries’ in accordance with IAS 27 and SIC 12 (the statement of interpretation which deals with special purpose entities) before applying the principles summarised below.
Whilst the new standard makes specific allowance for so called ‘pass through schemes’, so that contractual participation arrangements should be able to achieve derecognition treatment (provided certain specific rules set out in paragraph 19 of IAS 39 are complied with), it is recognised by the IASB that most securitisations will fail to qualify for derecognition (see BC63 of IAS 39). It is thought that most reporting originators in a securitisation transaction will not be able to derecognise asset transfers in their accounts under IAS 39 because, in a typically structured securitisation transaction, originators will normally retain some of the risks/rewards of the ownership of the asset (for example by virtue of some or more types of credit enhancement overcollateralisation/subordinated liability and a right to excess spread/profit).
Accordingly, most securitisations are likely to fall under paragraph 20 (c) of IAS 39, which essentially provides for two different treatments depending upon whether the reporting entity (eg, the originator) has retained control of the financial asset following transfer. If control over the asset is not retained, then in effect each of the assets and liabilities is derecognised/recognised as a separate item. Where control is retained (as will be the case in most securitisation transactions since the originator will also be appointed servicer of the assets and may also retain some rights to profit, excess spread or asset return on a subordinated basis), the financial asset must be recognised to the extent of the reporting entity’s ‘continuing involvement’.
IAS 39 helpfully lists a number of (non-exhaustive) illustrative examples of the application of the derecognition principles (see IAS 39, AG51). Of particular relevance to securitisation practitioners are examples (m) and (n), namely ‘clean up calls’ and ‘subordinated retained interests and credit guarantees’ respectively. IAS 39, AG52 gives a specific example of a loan portfolio sale at less than par value where the transferring entity retains a subordinated interest and has also retained control, and accordingly must therefore apply the continuing involvement approach prescribed by the new standard. It is likely that most currently accepted forms of overcollateralisation (such as provision of a subordinated loan or a deferred purchase price) will fall to be determined as ‘subordinated retained interest’ for the purposes of IAS 39.
Working through the example of a sale/transfer by a reporting entity of a portfolio of loan assets at a discounted price with a deferred purchase element (set out in greater detail in IAS 39, AG52) highlights a number of key differences from current accounting standards (especially FRS 5).
First, applying the rules of IAS 39, the consideration for a transaction (ie, ‘value’ received by the reporting entity for sale of loans) will have to be allocated in accordance with the fair value approach. Thus consideration for the purchase of the loans (in accordance with the example) is allocated according to the estimated fair value of the transferred portfolio and the continuing rights of the reporting entity to excess spread. The gain or loss on sale of the transferred portfolio is also calculated.
In addition, the reporting entity must also recognise the continuing involvement that results from the retention of the subordinated interest (ie, the deferred purchase price/ overcollateralisation) which is used as the first loss enhancement. Interestingly, this item has to be entered both in the debit and credit columns.
The resulting account entry requires a recording of the component elements of the transaction within the relevant debit/credit column, such that the following must all appear on the face of the balance sheet:
There is then an ongoing requirement to update the balance sheet to take account of, for example, losses allocated to the subordinated retained interest (which reduces both debt and credit columns equally).
IAS 39 (AG36) provides a useful flow chart illustrating the critical path for determining appropriate derecognition/ recognition treatment under the new standards, which for copyright reasons is not reproduced here.
Whatever the reaction of the securitisation industry to the new accounting standards may be, there is no longer an option to wait and see what happens. Since the new accounting standards will be effective as from the beginning of 2005, most of the companies for whom they are relevant will need to collate relevant data in relation to existing securitizations now. For arrangers and originators currently planning securitisation financing transactions, the new rules will need to be borne in mind.