Derecognition

Date recorded:

The Board continued its deliberations on an approach to derecognition of financial instruments and financial liabilities.

The notes below refer to Approach 1 and Approach 2. Briefly summarised, these are:

Approach 1

Derecognition Principle

The basic derecognition principle is that an entity should derecognise a financial asset when it no longer qualifies as an asset of the entity.

Derecognition Criteria

Approach 1 provides criteria to be used to determine when a financial asset no longer qualifies as the asset of the transferor. In particular, Approach 1 would require an assessment of whether the transferor presently has access, for its own benefit, to all of the cash flows or other economic benefits of the financial asset that the transferor recognised before the transfer.

Retained interests and beneficial interests

For transfers of part of (or an interest in) a financial asset or group of assets, Approach 1 would require the transferor to derecognise the entire financial asset (or group of financial assets) and recognise as a new financial asset (rather than as a part of the financial asset that the transferor recognised before the transfer) the retained interest in the financial asset (or group of financial assets). Similarly, Approach 1 requires a transferor to recognise as a new asset an investment that a transferor purchases from a transferee securitisation entity.

Approach 2

Derecognition Principle

Approach 2 requires an entity to derecognise a financial asset or a pre-defined component thereof if:

  • a. the contractual rights to the cash flows from the asset expire; or
  • b. the entity transfers the asset and:
    • (i) the entity is not involved in the asset after the transfer; or
    • (ii) the transferee has the practical ability to transfer the asset for its own benefit.

The 'continuing involvement' step (b)(i) and 'practical ability to transfer' test (b)(ii) are applied to a transferred part of a financial asset (or of a group of financial assets) only if that part comprises specifically identified cash flows and/or a proportionate share of the cash flows from that financial asset (or that group of financial assets). If there is more than one transferee, each transferee is not required to have a proportionate share of the cash flows provided that the transferring entity has a proportionate share.

Similarity to Current IAS 39

Approach 2 is similar in some ways to the current derecognition model in IAS 39 in that:

  • the same definition of a 'component' (or part of an asset) is used, with some clarifications to address known application issues;
  • the test of control is still used, although unlike the IAS 39 model that test has primacy;
  • many of the derecognition outcomes will be similar under Approach 2 as compared to IAS 39 (the notable exceptions being transfers, such as repos, involving readily obtainable assets).

Approach 2 does differ from IAS 39 in some important ways, and as a result is less complex to understand (and arguably to apply). The differences include:

  • no test of risks and rewards' and
  • no pass-through requirements.

Extent of Changes to IAS 39

Approach 1 proposes far-reaching changes to accounting for derecognition of financial assets. Approach 2 can be seen as an evolution to IAS 39 that improves that model.

Summary of Board Discussion

This was the first of several sessions at the February meeting. At this session the staff presented remaining issues identified when applying the two derecognition approaches to more complex cases. These issues were (applicability to approach 1 and/or 2 in parentheses):

  1. Scope - transfers of financial assets that should be considered for derecognition [Approach 1 and Approach 2]
  2. Derecognition or consolidation analysis first [Approach 1 and Approach 2]
  3. Identical transactions but non-identical accounting outcome (transfers of proportionate interests in cash flows) [Approach 2 only]
  4. Transfer of subordinated ('more risky') interests in a financial asset [Approach 2 only]
  5. Practical ability to transfer in the context of securitisations [Approach 2 only]
  6. Remaining interest in the asset that was the subject of the transfer [Approach 2 only]
  7. Transfer of a part of an equity instrument [Approach 2 only]

Scope - transfers of financial assets that should be considered for derecognition

The staff noted that the proposed scope of transactions to which the derecognition process was to be applied could potentially be too narrow as it excluded originations, issuances and expiries. This was considered to open up structuring opportunities. In the proposed change the staff also clarified that this only relates to financial instruments. This confused some Board members as they believed the broad principles should potentially be applicable to all assets and liabilities.

However, staff highlighted that due to time constraints the efforts focussed on financial instruments, but the principles are to be revisited in the future.

The Board agreed.

Derecognition or consolidation analysis first

The staff proposed that for approach 1 derecognition is assessed before consolidation while for approach 2 derecognition is assessed after consolidation (similar to existing IAS 39). The Board had a lively discussion on that and it emerged that the real issue behind this was whether there was some continuing involvement left in the entity. The Board agreed to look only at the reporting entity in all situations.

Identical transactions but non-identical accounting outcome

The staff continued to explain that some transfers of proportionate shares in cash flows can result in different accounting outcomes under approach 2. The staff proposed to add an exemption from continuing involvement in has a proportionate share of assets is transferred.

Transfer of subordinated ('more risky') interests in a financial asset

One Board member informed the staff that he believes approach 2 would prevent derecognising higher risk interests in a financial asset while allowing derecognising interests where the transferor retains more risk, because in the first case a disproportionate share was transferred. This was considered being counterintuitive. The Board agreed that the wording could be clarified to resolve this issue, but this could be taken offline.

Practical ability to transfer in the context of securitisations

The staff informed the Board that the 'practical ability' often would prevent a transferor to derecognise assets transferred into an SPE. Staff presented a simple structure to overcome this issue. Staff proposed to make clear that the transferee to which the practical ability test is applied is the entity with which the transferor had agreements that resulted in continuing involvement. The Board agreed.

Remaining interest in the asset that was the subject of the transfer

The staff recommended clarifying in the exposure draft that under approach 2 that any remaining interest in the asset subject to transfer should be accounted as part of the previously recognised asset. The Board had a lengthy discussion on this, largely because the Board is split about the approach to be taken. In the end, the Board agreed.

Transfer of a part of an equity instrument

The staff recommended to the Board that transfers of parts of equity instruments would qualify as a component under approach 2 and that the asset definition in the model should be amended accordingly.

At the end of the session the chairman took an indicative vote on the two approaches. A majority voted for approach 2 (similar to the current IAS 39 model) with a considerable minority favouring approach 1. The ED will contain both approaches - one as an alternative view.

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