to determine whether a modification is substantial would not always be appropriate
because of potential inconsistencies with the requirements in IAS 39 for impaired
financial assets, which are now in IFRS 9.
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The committee did not explicitly conclude on this part of the staff analysis, particularly
the question of when it would be appropriate to regard a modification or exchange as the
expiry or in-substance extinguishment of the original asset. Instead they simply noted
that, in their view, derecognition of the original Greek government bonds would be the
appropriate accounting treatment however this particular transaction was assessed, i.e.
whether it was viewed as (a) an actual expiry of the rights of the original asset or (b) as a
substantial modification that should be accounted for as an extinguishment of the original
asset (because of the extensive changes in the assets’ terms). An agenda decision setting
out the committee’s conclusions was published in September 2012.7
Whilst that discussion resolved most of the issues associated with the restructuring of Greek
government bonds, the wider topic continues to require the application of judgement and,
as a result, potentially leads to inconsistent approaches being applied by different entities.
3.4.3
Novation of contracts to intermediary counterparties
A change in the terms of a contract may take the legal form of a ‘novation’. In this
context novation means that the parties to a contract agree to change that contract so
that an original counterparty is replaced by a new counterparty.
For example, a derivative between a reporting entity and a bank may be novated to a
central counterparty (CCP) as a result of the introduction of new laws or regulations. In
these circumstances, the IASB explains that through novation to a CCP the contractual
rights to cash flows from the original derivative have expired and as a consequence the
novation meets the derecognition criteria for a financial asset. [IFRS 9.BC6.332-337].
Whilst the IASB reached the above conclusion in relation to novations of over-the-
counter derivatives, it is our view that the principle is applicable to all novations of
contracts underlying a financial instrument. Accordingly, when a counterparty changes
as a result of a novation, the financial instrument should be derecognised and a new
financial instrument should be recognised. Although such a change may not be expected
to give rise to a significant gain or loss when the financial instrument derecognised and
the new financial instrument recognised are both measured at fair value through profit
or loss, the bid/ask spread and the effect of change in counterparty on credit risk may
cause some value differences. Furthermore, a novation may result in discontinuation of
hedge accounting if the original financial instrument was a derivative designated in a
hedging relationship (see Chapter 49 at 8.3 for further details).
3.4.4 Write-offs
When an entity applies IFRS 9, it is required to directly reduce the gross carrying
amount of a financial asset when it has no reasonable expectations of recovery. Such a
write-off is regarded as the asset being derecognised – effectively it is seen as an in-
substance expiry of the associated rights. Write-offs can also relate to a portion of an
asset. For example, consider an entity that plans to enforce the collateral on a financial
asset and expects to recover no more than 30% of the financial asset from the collateral.
If the entity has no reasonable prospects of recovering any further cash flows from the
financial asset, it should write off the remaining 70%. [IFRS 9.5.4.4, B3.2.16(r), B5.4.9].
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3.5
Has the entity ‘transferred’ the asset?
An entity is regarded by IFRS 9 as ‘transferring’ a financial asset if, and only if, it either:
(a) transfers the contractual rights to receive the cash flows of the financial asset
(see 3.5.1 below); or
(b) retains the contractual rights to receive the cash flows of the financial asset, but
assumes a contractual obligation to pay the cash flows on to one or more recipients
in an arrangement that meets the conditions in 3.5.2 below [IFRS 9.3.2.4] (a so-called
‘pass-through arrangement’).
This might be the case where the entity is a special purpose entity or trust, and
issues to investors beneficial interests in financial assets that it owns and provides
servicing of those assets. [IFRS 9.B3.2.2].
These conditions are highly significant for securitisations and similar transactions that
fall within (b) because the entity retains the contractual right to receive cash.
3.5.1
Transfers of contractual rights to receive cash flows
The discussion in this section refers to Box 4 in the flowchart at 3.2 above.
IFRS 9 does not define what they mean by the phrase ‘transfers the contractual rights
to receive the cash flows of the financial asset’ in (a) in 3.5 above, possibly on the
assumption that this is self-evident. However, this is far from the case, since the phrase
raises a number of questions of interpretation.
There are two key uncertainties about the meaning of ‘transferring the contractual rights’
(which in turn determines whether a transaction falls within (a) or (b) in 3.5 above):
• whether it is restricted to transfers of legal title only or also encompasses transfers
of equitable title or an equitable interest (see 3.5.1.A below); and
• the effect of conditions attached to the transfers (see 3.5.1.B below).
While both of these are of great significance to securitisations (see 3.6 below), they also
have implications for other transactions. These issues were discussed in 2006 by both
the Interpretations Committee and the IASB. However, as described at 3.3.2 above, the
Interpretations Committee’s tentative decision not to issue further guidance and the
interpretation of the issues that had so far been published were both withdrawn in
January 2007. There is no clear evidence that practice has changed as a result of the
views that had been expressed by the IASB and the Interpretations Committee but, as
this has demonstrated a lack of clear underlying principles, it would be no surprise to
find that entities have different interpretations of the requirements.
In the context of the restructuring of Greek government bonds (see 3.4.2 above), the
Interpretations Committee considered whether an exchange of debt instruments
between a borrower and a lender should be regarded as a transfer. It was noted that the
bonds were transferred back to the issuer rather than to a third party and, as a
consequence, it was agreed that this particular restructuring should not be regarded as
a transfer.8 However, it was noted during the committee’s discussion and in the
comment process that applying such a conclusion more widely might not always be
appropriate, e.g. in the case of a short-term sale and repurchase agreement over a bond
with the bond issuer or the simple repurchase of a bond by the issuer for cash.
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3.5.1.A
M
eaning of ‘transfers the contractual rights to receive the cash flows’
In many jurisdictions, the law recognises two types of title to property: (a) legal title; and
(b) ‘equitable’, or beneficial title. In general, legal title defines who owns an asset at law
and equitable title defines who is recognised as entitled to the benefit of the asset.
Transfers of legal title give the transferee the ability to bring an action against a debtor
to recover the debt in its own name. In equitable transfers, however, the transferee joins
the transferor in an action to sue the debtor for recovery of debt. As noted above, the
issue here is whether ‘transfers of contractual rights’ are limited to transfers of legal title.
In a typical securitisation transaction across many jurisdictions, the transfer of
contractual rights to receive cash flows are achieved via equitable or beneficial transfer
of title in that asset, as the transfer of legal title in the asset would simply not be possible
without either:
• a tri-partite agreement between the corporate entity, the finance provider and the
debtor; or
• a clause in the standard terms of trade allowing such a transfer at the sole discretion
of the corporate entity without the express consent of the debtor, so that transfer
can be effected by a subsequent bi-partite agreement between the corporate entity
and the finance provider.
The consent of the debtor is not normally obtained, or indeed practically obtainable, in
many securitisations and similar transactions. In these arrangements, all cash flows that
are collected are contractually payable to a new eventual recipient – i.e. the debtor
continues to pay the transferor, while the transferor loses the right to retain any cash
collected from the debtor without actually transferring the contract itself.
In March 2006 the Interpretations Committee began to consider whether there can be
a transfer of the contractual right to receive cash flows in an equitable transfer.9 The
Interpretations Committee had already concluded, in November 2005, that retaining
servicing rights (i.e. continuing to administer collections and distributions of cash as
agent for the transferee) does not in itself preclude derecognition.10 However, the
Interpretations Committee then considered whether retention by the transferor of the
contractual right to receive the cash from debtors for distribution on to other parties (as
must inevitably happen if debtors are not notified) means that such a transaction does
not meet test (a) in 3.5 above, and thus must meet test (b) (pass-through) in order to
achieve derecognition. The Interpretations Committee referred this issue to the IASB,
which indicated in September 2006 that:
‘[a] transaction in which an entity transfers all the contractual rights to receive the
cash flows (without necessarily transferring legal ownership of the financial asset),
would not be treated as a pass-through. An example might be a situation in which
an entity transfers all the legal rights to specifically identified cash flows of a
financial asset (for example, a transfer of the interest or principal of a debt
instrument). Conversely, the pass-through test would be applicable when the
entity does not transfer all the contractual rights to cash flows of the financial asset,
such as disproportionate transfers.’11
3900 Chapter 48
The statement that such a transaction ‘would not be treated as a pass-through’ means
(in terms of the flowchart in Figure 48.1 at 3.2 above) that the answer to Box 4 is ‘Yes’,
such that the pass-through test in Box 5 (see 3.5.2 below) is by-passed.
The IASB’s conclusion appears to concede that the references in IFRS 9 to a transfer of the
‘contractual’ right to cash flows was intended to include an equitable transfer of those rights,
a conclusion that the IASB repeated in its April 2009 Exposure Draft – Derecognition. In
our view, the transfer of the contractual rights to cash flows encompass both the transfer of
legal title in the asset as well as transfer of equitable or beneficial title in the asset.
The IASB commented that ‘the pass-through test would be applicable when the entity
does not transfer all the contractual rights to cash flows of the financial asset, such as
disproportionate transfers’.
For example, if an entity transfers the rights to 90% of the cash flows from a group of
receivables but provides a guarantee to compensate the buyer for any credit losses up
to 8% of the principal amount of the receivables, the derecognition provisions are
applied to the group of financial assets in its entirety. [IFRS 9.3.2.2(b)]. This means that the
answer to Box 4 in the flowchart will be ‘No’ (since some, not all, of the cash flows of
the entire group of assets have been transferred), thus requiring the pass-through test in
Box 5 to be applied. In contrast, the pass-through test would not need to be applied
where the entity transfers the contractual right to receive 100% of the cash flows.
It is difficult to comprehend the circumstances in which the pass-through test would ever
be successfully applied to a disproportionate transfer. Accordingly, this view from the IASB
would, in effect, disqualify virtually all disproportionate transfers from derecognition.
The IASB’s interpretation gives no answer to an even more critical question. If the
derecognition rules need to be applied separately to loans and derivatives or guarantees,
how does this affect:
• the definition of a ‘transfer’ (if all the cash flows are transferred); or
• the application of the pass-through test (if the transfer is of a disproportionate
share of the cash flow)?
Before this re-examination by the IASB of the meaning of ‘transfer’, it was common in
some jurisdictions to apply the legal title test to transfers of financial assets to a SPE in
securitisation arrangements, rather than relying on an equitable transfer. After the
withdrawal of the ‘non-interpretation’ (see 3.3.2 above), it is likely that those entities
have continued to apply their previous practice. However the discussions have, yet
again, highlighted the uncertainty at the heart of the derecognition rules in IFRS 9 which
means that there must be different treatments in practice. Until there is a conclusive
interpretation, entities must establish an accounting policy that they apply consistently
to all such transactions, whether they are transfers or pass-throughs.
The implications of the IASB’s discussion on securitisation transactions are discussed
further at 3.6.5 below.
3.5.1.B
Transfers subject to conditions
An entity may transfer contractual rights to cash flows but subject to conditions. The
Interpretations Committee identified the following main types of condition:
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• Conditions relating to the existence and legal status of the asset at the time of the
transfer
These include normal warranties as to the condition of the asset at the date of
transfer and other guarantees affecting the existence and accuracy of the amount
of the receivable that may not be known until after the date of transfer.
• Conditions relating to th
e performance of the asset after the time of transfer
These include guarantees covering future default, late payment or changes in credit
risk, guarantees relating to changes in tax, legal or regulatory requirements, where
the buyer may be able to require additional payments if it is disadvantaged or – in
some cases – demand reversal of the transaction, or guarantees covering future
performance by the seller that might affect the recoverable amount of the debtor.
• Offset arrangements
The original debtor may have the right to offset amounts against balances owed to
the transferor for which the transferor will compensate the transferee. There may
also be tripartite offset arrangements where a party other than the original debtor
(e.g. a subcontractor) has such offset rights.12
All securitisations (and indeed, most derecognitions, whether of financial or non-
financial assets) include express or implied warranties regarding the condition of the
asset at the date of transfer. In the case of a securitisation of credit card receivables,
these might include a representation that, for example, all the debtors transferred are
resident in a particular jurisdiction, or have never been in arrears for more than one
month in the previous two years. In our view, such warranties should not affect whether
or not the transaction achieves derecognition.
It is a different matter when it comes to guarantees of post-transfer performance. In
particular, one of the issues identified by the Interpretations Committee – guarantees
covering future default, late payment or changes in credit risk – links to the related
debate regarding the transfer of groups of financial assets where the guarantees may
have been provided by a third party (see 3.3.2 above).
In July 2006 the Interpretations Committee decided to refer this issue to the IASB,
which considered it at its September 2006 meeting. The IASB broadly confirmed our
view as set out above. In its view neither conditions relating to the existence and value
of transferred cash flows at the date of transfer nor conditions relating to the future
performance of the asset would affect whether the entity has transferred the contractual
rights to receive cash flows13 (i.e. Box 4 in Figure 48.1 at 3.2 above). In other words, a
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