Derecognition of Financial Assets

5.1 Derecognition of Financial Assets

5.1.1 Under IAS 39, derecognition of a financial asset is appropriate if either one of these two criteria is met:

(1) The contractual rights to the cash flows of the financial asset have expired, or (2) The financial asset has been transferred (e.g., sold) and the transfer qualifies for derecogni-

tion based on an evaluation of the extent of transfer of the risks and rewards of ownership of the financial asset.

5.1.2 The first criterion for derecognition of a financial asset is usually easy to apply. The con- tractual rights to cash flows may expire, for instance, because a customer has paid off an obligation

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to the entity or an option held by the entity has expired worthless. In these cases, derecognition is appropriate because the rights associated with the financial asset no longer exist.

5.1.3 The application of the second criterion for derecognition of financial assets is often more complex. It relies on an assessment of the extent to which the entity has transferred the risks and rewards of ownership of the asset and, if that assessment is not conclusive, an assessment of

whether the entity has retained control of the transferred financial asset.

5.1.4 More specifically, when an entity sells or otherwise transfers a financial asset to another party, the entity (transferor) must evaluate the extent to which it has transferred the risks and re- wards of ownership of the transferred financial asset to the other party (transferee). This evaluation is based on a comparison of the exposure to the variability in the amounts and timing of the net cash flows of the asset before and after the transfer of the asset.

5.1.5 IAS 39 distinguishes among three types of transfers: (1) The entity has retained substantially all risks and rewards of ownership of the transferred

asset. (2) The entity has transferred substantially all risks and rewards of ownership of the trans-

ferred asset. (3) The entity has neither retained nor transferred substantially all risks and rewards of owner-

ship of the transferred asset (i.e., cases that fall between situations (1) and (2) above).

5.1.6 If an entity transfers substantially all risks and rewards of ownership of a transferred finan- cial asset—situation (2) above—the entity derecognizes the financial asset in its entirety.

Example

Examples of transactions where an entity has transferred substantially all risks and rewards of ownership—situation (1) above—include

• A sale of a financial asset where the seller (transferor) does not retain any rights or obliga- tions (e.g., an option or guarantee) associated with the sold asset • A sale of a financial asset where the transferor retains a right to repurchase the financial asset, but the repurchase price is set as the current fair value of the asset on the repurchase date

• A sale of a financial asset where the transferor retains a call option to repurchase the trans- ferred asset, at the transferor’s option, but that option is deep-out-of-the-money (i.e., it is not probable that the option will be exercised)

• A sale of a financial asset where the transferor writes a put option that obligates it to repur- chase the transferred asset, at the transferee’s option, but that option is deep-out-of-the- money

5.1.7 On derecognition, if there is a difference between the consideration received and the carry- ing amount of the financial asset, the entity recognizes a gain or loss in profit or loss on the sale. For a derecognized financial asset classified as available for sale, the gain or loss is adjusted for

any unrealized holding gains or losses that previously have been included in equity for that finan- cial asset.

Example

If the carrying amount of a financial asset is $26,300 and the entity sells it for cash of $26,500 in a transfer that qualifies for derecognition, an entity makes these entries:

Dr Cash

Cr Asset

Cr Gain on sale

If the asset sold was an AFS financial asset, the entries would look differently. Changes in fair value of available-for-sale (AFS) financial assets are not recognized in profit or loss, but as a separate component of equity until realized. If changes in fair value of $2,400 had previously been recog- nized as a separate component of equity, the entity would make these entries on derecognition, as- suming the carrying amount was $26,300 and the sales price was $26,500:

Dr Cash

Dr Available-for-sale gains recognized in equity

Cr Asset

Cr Gain on sale

Chapter 25 / Financial Instruments: Recognition and Measurement (IAS 39)

5.1.8 If an entity transfers a financial asset but retains substantially all risks and rewards of own- ership of the financial asset—situation (1) above—IAS 39 requires the entity to continue to recog- nize the financial asset in its entirety. No gain or loss is recognized as a result of the transfer. This situation is sometimes referred to as a failed sale.

Example

Examples of transactions where an entity retains substantially all risks and rewards of ownership— situation (1)—include

• A sale of a financial asset where the asset will be returned to the transferor for a fixed price at a future date (e.g., a sale and repurchase [repo] transaction) • A securities lending transaction • A sale of a group of short-term accounts receivables where the transferor issues a guarantee

to compensate the buyer for any credit losses incurred in the group and there are no other substantive risks transferred

• A sale of a financial asset where the transferor retains a call option to repurchase the trans- ferred asset, at the transferor’s option, where the option is deep-in-the-money (i.e., it is highly probable that the option will be exercised)

• A sale of a financial asset where the transferor issues (writes) a put option that obligates it to repurchase the transferred asset, at the transferee’s option, where the option is deep-in-the money

• A sale of a financial asset where the transferor enters into a total return swap with the trans- feree that returns all increases in fair value of the transferred asset to the transferor and pro- vides the transferee with compensation for all decreases in fair value

Example

An entity sells an asset for a fixed price but simultaneously enters into a forward contract to repur- chase the transferred financial asset in one year at the same price plus interest. In this case, even though the entity has transferred the financial asset, there has been no significant change in the en- tity’s exposure to risk and rewards of the asset. Due to the agreement to repurchase the asset for a fixed price on a future date, irrespective of what the market price of the asset may be on that date, the entity continues to be exposed to any increases or decreases in the value of the asset in the pe- riod between the sale and the repurchase. In substance, therefore, a repurchase transaction is similar to a borrowing of an amount equal to the fixed price plus interest with the transferred asset serving as collateral to the transferee.

For example, if an entity sells a financial asset for $14,300 in cash and at the same time enters into an agreement with the buyer to repurchase the asset in three months for $14,500, the sale would not qualify for derecognition. The asset would continue to be recognized, and the seller would instead recognize a borrowing from the buyer, as follows:

Dr Cash

Cr Borrowing

In the period between the sale and repurchase of the financial asset, the entity would accrue interest expense on the borrowing for the difference between the sale price ($14,300) and repurchase price ($14,500):

Dr Interest expense

Cr Borrowing

On the date of the repurchase, the entity would record the repurchase as follows: Dr Borrowing

Cr Cash

5.1.9 The evaluation of the extent to which derecognition of a financial asset is appropriate be- comes more complex when the entity has retained some risks and rewards of ownership of a finan- cial asset and transferred others. To do this evaluation, it may be necessary to perform a quantita-

tive comparison of the entity’s exposure before and after the transfer to the risks and rewards of the transferred asset. If the evaluation results in the conclusion that the entity has neither retained nor transferred substantially all risks and rewards of ownership—situation (3) above—derecognition depends on whether the entity has retained control of the transferred financial asset. An entity has lost control if the other party (the transferee) has the practical ability to sell the asset in its entirety to a third party without attaching any restrictions to the transfer.

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5.1.10 If the transferor has lost control of the transferred asset, the financial asset is derecognized in its entirety. If there is a difference between the asset’s carrying amount (adjusted for any de- ferred unrealized holding gains and losses in equity) and the payment received, a gain or loss is recognized in the same way as in situation (1).

5.1.11 If the transferor has retained control over the transferred asset, the entity continues to rec- ognize the asset to the extent of its continuing involvement. The continuing involvement is deter- mined based on the extent to which the entity continues to be exposed to changes in amounts and

timing of the net cash flows of the transferred asset (i.e., based on its nominal or maximum expo- sure to changes in net cash flows of the transferred asset).

Example

An example of a transaction where an entity neither retains nor transfers substantially all risks and rewards of ownership—situation (3)—is

• A sale of a group of accounts receivables where the transferor issues a guarantee to compen- sate the buyer for any credit losses incurred in the group up to a maximum amount that is less than the expected credit losses in the group

For instance, if an entity sells a loan portfolio that has a carrying amount of $100,000 for $99,000 and provides the buyer with a guarantee to compensate the buyer for any impairment losses up to $1,000 when expected losses based on historical experience is $3,000, the entity may determine that it has neither retained nor transferred substantially all risks and rewards of ownership. Therefore, it must evaluate whether it has retained control of the transferred asset. If the entity has retained con- trol, the seller would continue to recognize $1,000 as an asset and a corresponding liability to reflect its continuing involvement in the asset (i.e., the maximum amount it may pay under the guarantee) and derecognize the remainder of the carrying amount of the loan portfolio of $99,000.

5.1.12 The next table summarizes the accounting treatments for the three types of transfers just described.

Situation Accounting treatment The transferor has retained substantially all risks and rewards—

Continued recognition of the transferred asset.

situation (1) above.

Any consideration received is recognized as a borrowing.

The transferor has neither retained

The transferor has

Continued recognition of the transferred asset

nor transferred substantially all risks

retained control.

to the extent of the transferor’s continuing

and rewards—situation (3) above.

involvement in the asset. The transferor recognizes a gain or loss for any part that qualifies for derecognition.

The transferor has lost

Derecognition. The transferor recognizes any

control.

resulting gain or loss.

The transferor has transferred substantially all risks and

Derecognition. The transferor recognizes any

rewards—situation (2) above.

resulting gain or loss.

5.1.13 Pass-Through Arrangements

5.1.13.1 It is not always necessary for an entity actually to transfer its rights to receive cash flows from a financial asset in order for the asset to qualify for derecognition under IAS 39. Under cer-

tain conditions, contractual arrangements where an entity continues to collect cash flows from a financial asset it holds, but immediately passes on those cash flows to other parties, may qualify for derecognition if the entity is acting more like an agent (or “post box”) than a principal in the ar- rangement. Under such circumstances, the entity’s receipts and payments of cash flows may not meet the definitions of assets and liabilities.

5.1.13.2 Thus, IAS 39 specifies that when an entity retains the contractual rights to receive the cash flows of a financial asset (the “original asset”), but assumes a contractual obligation to pay those cash flows to one or more entities (the “eventual recipients”), the entity treats the transaction as a transfer of a financial asset if, and only if, all of these three conditions are met:

(1) The entity has no obligation to pay amounts to the eventual recipients unless it collects equivalent amounts from the original asset. Short-term advances by the entity with the right of full recovery of the amount lent plus accrued interest at market rates do not violate this condition.

Chapter 25 / Financial Instruments: Recognition and Measurement (IAS 39)

(2) The entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows.

(3) The entity has an obligation to remit any cash flows it collects on behalf of the eventual re- cipients without material delay. In addition, the entity is not entitled to reinvest such cash flows, except for investments in cash or cash equivalents during the short settlement period from the collection date to the date of required remittance to the eventual recipients, and interest earned on such investments is passed to the eventual recipients.

5.1.13.3 For arrangements that meet these conditions, the requirements regarding evaluating transfer of risks and rewards just described are applied to the assets subject to that arrangement to determine the extent to which derecognition is appropriate. If the three conditions are not met, the asset continues to be recognized.

5.1.14 Consolidation

In consolidated financial statements, the derecognition requirements are applied from the perspective of the consolidated group. Before applying the derecognition principles in IAS 39, therefore, an entity applies IAS 27 and SIC 12, Consolidation—Special-Purpose Entities, to deter- mine which entities should be consolidated. Special-purpose entities (SPEs) are entities that are created to accomplish a narrow and well-defined objective and often have legal arrangements that impose strict and sometimes permanent limits on the decision-making powers of the governing board, trustee, or management of the SPEs. For instance, SPEs often are created by transferors of financial assets to effect a securitization of those financial assets. Under SIC 12, the evaluation of whether an SPE should be consolidated is based on an evaluation of whether the substance of the relationship indicates that the SPE is controlled. Four indicators are: (1) the activities are conducted according to specific business needs, so that the entity obtains benefits; (2) decision-making pow- ers including by autopilot to obtain the majority of the benefits; (3) rights to obtain the majority of the benefits; and (4) majority of the residual or ownership risks. Where an SPE is required to be consolidated, a transfer of a financial asset to that SPE from the parent or another entity within the group does not qualify for derecognition in the consolidated financial statements. The assets are derecognized only to the extent the SPE in turn sells the transferred assets to a third party or enters into a pass-through arrangement and that sale or arrangement meets the condition for derecogni- tion.

5.1.15 Summary

The eight steps that are involved in the evaluation of whether to derecognize a financial asset under IAS 39 are

(1) Consolidate all subsidiaries (including any SPE). (2) Determine whether the derecognition principles are applied to a part or all of an asset (or

group of similar assets). (3) Have the rights to the cash flows from the asset expired? If yes, derecognize the asset. If no, go to step 4. (4) Has the entity transferred its rights to receive the cash flows from the asset? If yes, go to 6. If no, go to step 5. (5) Has the entity assumed an obligation to pay the cash flows from the asset that meets three conditions? As discussed in the previous section, the three conditions are that (1) the transferor has no obligation to pay cash flows unless it collects equivalent amounts from the original asset, (2) the transferor is prohibited from selling or pledging the original asset, and (3) the transferor has an obligation to remit the cash flows without material delay. If yes, go to step 6. If no, continue to recognize the asset.

(6) Has the entity transferred substantially all risks and rewards? If yes, derecognize the asset. If no, go to step 7. (7) Has the entity retained substantially all risks and rewards? If yes, continue to recognize the asset. If no, go to step 8. (8) Has the entity retained control of the asset? If yes, continue to recognize the asset to the extent of the entity’s continuing involvement. If no, derecognize the asset.

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The flowchart illustrates these steps.

1. Consolidate all subsidiaries (including any SPE).

2. Determine whether the principles should be applied to a part or all of an asset (or group).

Yes

3. Have the rights to the cash flows expired?

No

4. Has the entity transferred the right to receive the cash flows?

Yes No

5. Has it assumed an

No

obligation to pay that meets the 3 conditions?

Yes

6. Has it transferred substantially all risks and rewards?

A. Derecognize the

7. Has it retained

Yes

B. Continue to

substantially all risks

recognize the asset.

and rewards?

No No

8. Has it retained control?

Yes

C. Continue to recognize the asset to the extent of the continuing involvement.

Chapter 25 / Financial Instruments: Recognition and Measurement (IAS 39)

Case Study 4

This case illustrates the application of the principle for derecognition of financial assets

Facts

During the reporting period, Entity A has sold various financial assets: (a) Entity A sells a financial asset for $10,000. There are no strings attached to the sale, and no

other rights or obligations are retained by Entity A. (b) Entity A sells an investment in shares for $10,000 but retains a call option to repurchase the

shares at any time at a price equal to their current fair value on the repurchase date. (c) Entity A sells a portfolio of short-term account receivables for $100,000 and promises to pay up to $3,000 to compensate the buyer if and when any defaults occur. Expected credit losses are significantly less than $3,000, and there are no other significant risks.

(d) Entity A sells a portfolio of receivables for $10,000 but retains the right to service the receiv- ables for a fixed fee (i.e., to collect payments on the receivables and pass them on to the buyer of the receivables). The servicing arrangement meets the pass-through conditions.

(e) Entity A sells an investment in shares for $10,000 and simultaneously enters into a total return swap with the buyer under which the buyer will return any increases in value to Entity A and Entity A will pay the buyer interest plus compensation for any decreases in the value of the in- vestment.

(f) Entity A sells a portfolio of receivables for $100,000 and promises to pay up to $3,000 to compensate the buyer if and when any defaults occur. Expected credit losses significantly ex- ceed $3,000.

Required

Help Entity A by evaluating the extent to which derecognition is appropriate in each of the above cases.

Solution

(a) Entity A should derecognize the transferred financial asset, because it has transferred all risks and rewards of ownership. (b) Entity A should derecognize the transferred financial asset, because it has transferred substan- tially all risks and rewards of ownership. While Entity A has retained a call option (i.e., a right that often precludes derecognition), the exercise price of this call option is the current fair value of the asset on the repurchase date. Therefore, the value of call option should be close to zero. Accordingly, Entity A has not retained any significant risks and rewards of ownership.

(c) Entity A should continue to recognize the transferred receivables because it has retained sub- stantially all risks and rewards of the receivables. It has kept all expected credit risk, and there are no other substantive risks.

(d) Entity A should derecognize the receivables because it has transferred substantially all risks and rewards. Depending on whether Entity A will obtain adequate compensation for the servicing right, Entity A may have to recognize a servicing asset or servicing liability for the servicing right.

(e) Entity A should continue to recognize the sold investment because it has retained substantially all the risks and rewards of ownership. The total return swap results in Entity A still being ex- posed to all increases and decreases in the value of the investment.

(f) Entity A has neither retained nor transferred substantially all risks and rewards of the trans- ferred assets. Therefore, Entity A needs to evaluate whether it has retained or transferred con- trol. Assuming the receivables are not readily available in the market, Entity A would be con- sidered to have retained control over the receivables. Therefore, it should continue to recognize the continuing involvement it has in the receivables, that is, the lower of (1) the amount of the asset ($100,000) and (2) the maximum amount of the consideration received it could be re- quired to repay ($3,000).