Securitization, with its use of special purpose vehicles (SPVs) and potential - in some jurisdictions - for off-balance-sheet financing, has not been exempt from the controversies caused by the accounting scandals of recent years. The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have responded by introducing new standards, or modifications to existing standards, to give greater clarity and certainty about the appropriate accounting treatment for securitizations. These groups hope to move towards a single global framework at some point but, although the FASB and IASB have a convergence programme in place, much remains to be done. Other jurisdictions are also keen to create a globally accepted set of standards. In the UK, for example, the Accounting Standards Board (ASB) is converging with International Financial Reporting Standards (IFRS), commonly referred to as International Accounting Standards (IAS). IFRS will have implications in many areas, not least on the UK's securitization industry.

UK Gaap

Accounting is not usually the prime motivation for an originator contemplating a securitization transaction, but it can be an important consideration. Historically this has been particularly true for regulated institutions, such as banks and building societies, where more often than not the regulatory treatment has been linked to the FRS5 accounting treatment.

Since 1994 the relevant pronouncement has been FRS 5 - Reporting the Substance of Transactions. FRS 5 sets out criteria that enable the originator to arrive at a conclusion as to whether the securitization transaction should be accounted for as:

1. derecognition of the securitized assets and funding with a gain/loss on sale;
2. linked presentation with the balance sheet showing an offset of the non-recourse finance against the securitized assets but, in most situations, no gain or loss on sale; or
3. separate recognition of the securitized assets and the funding within assets and liabilities respectively.

Typically, few originators have achieved derecognition, because the risks and rewards are retained to some degree in most securitization transactions. The most common accounting treatments in the UK have been either linked presentation (provided the conditions set out in paragraphs 26 and 27 of FRS 5 are met - in particular that the element of recourse is not unlimited) or separate presentation.

FRS 5 also introduced the concept of quasi subsidiaries and required the full consolidation of such entities or, in cases where the condition of paragraph 26 and 27 are met from the point of view of the group, inclusion of the quasi subsidiary using a linked presentation.

In practice most SPVs in securitization transactions have met the definition of a quasi subsidiary and have been required to be consolidated. If certain conditions set out in FRS 5 are met, then linked presentation has applied at both the solo and consolidated level. In this way the group would show the proceeds of the non-recourse funding deducted from the securitized assets on the face of the balance sheet within a single asset caption.

Although linked presentation has its critics, particularly from the accounting purists, and is perhaps in need of a little refreshing, it has been regarded generally in the UK as a sensible and pragmatic solution for the accounting industry. The concept has been readily understood by preparers and users of financial statements. However, the use of linked presentation under UK generally accepted accounting principles (Gaap) has been attacked on two fronts:

• Recent changes to section 258 of the Companies Act 1985 and FRS 2 - Subsidiary Undertakings have amended and widened the definition under UK Gaap of a subsidiary undertaking to be more closely aligned to the equivalent definition to IFRS. The result is that many SPVs that were previously accounted for as quasi subsidiaries will now have to be fully consolidated as subsidiary undertakings within the meaning of the Act and FRS 2. Under the provisions of FRS 5 linked presentation is not available for legal subsidiaries.
• Further proposed changes to UK Gaap are likely to remove the availability of linked presentation for financial assets altogether. On April 21 2005, as part of its convergence agenda with IFRS, the ASB issued an exposure draft amending FRS 26 - Financial Instruments: Measurement. This marks the end of the availability of linked presentation within UK Gaap for many securitization transactions as currently structured because linked presentation is not available under IFRS. The amendment proposes that the extension of the scope of FRS 26 would be effective for accounting periods beginning on or after January 1 2007, although the ASB is seeking views on whether such a timetable is practicable.

International accounting standards

The concept of linked presentation does not exist in IFRS, which is a big change for those now adopting these standards. Originator/transferors and investors that will be most affected by the adoption of, and changes to, IFRS are those with securities listed on EU stock exchanges that are regulated markets for accounting periods that began on or after January 1 2005. From this date listed companies in all EU countries are required to present group financial statements in accordance with IFRS.

Companies with listed debt fall within the scope of this EU regulation. It only applies to consolidated accounts, however, and many SPVs that only have listed debt are single companies that are not required to prepare consolidated accounts. Despite this, it is possible that the national listing authorities in member states might choose to require such companies to use IFRS under their listing rules. In the UK for solo (as opposed to consolidated) accounts there is a choice for accounting periods beginning on or after January 1 2005 brought in by changes to the Companies Act. This will mean a choice between applying IFRS or UK Gaap. This choice will also apply to companies that produce consolidated accounts but that are not caught by EU regulation because that company has no listed securities.

Under IFRS, the relevant standards are:

• IAS 27(Revised), which, among other things, details the accounting principles under which an entity should consolidate another entity;
• SIC 12, which focuses on the consolidation of SPVs; and
• IAS 39(Revised), which covers the recognition, measurement and derecognition of financial assets and liabilities.

In June 2003 the IASB undertook a consolidation project to revise IAS 27 and SIC 12. The main objectives of this project are to develop a comprehensive definition of control, to consider circumstances in which SPVs should be consolidated and to address both consolidation policy and procedures. It was the board's intention to issue an exposure draft by mid-2005 that would incorporate a new definition of control, but at the time of writing this has not yet occurred. We understand that the board will explore the impact on SPVs of the new exposure draft before release but will not incorporate into the exposure draft any specific guidance with regard to SPVs. Consequently, there remains uncertainty of the impact - if any - of revised IAS 27 and SIC 12 on current IAS treatment of SPVs.

The revised IAS 39 was issued on December 17 2003 and is effective for periods beginning on or after January 1 2005.

IAS 39 (Revised) introduced the decision tree shown in Figure 1, which illustrates how to evaluate whether and to what extent a financial asset is derecognized.

Under IAS 39 (Revised), derecognition principles and tests apply both at consolidated and entity level (that is, at the consolidated level it is necessary to apply SIC 12 before considering derecognition). The decision tree in Figure 1 illustrates the order in which the principles of risks and rewards and control must be considered, thus removing any ambiguity.

Figure 1: Derecognizing a financial asset

Clarifying derecognition

Although the revised IAS 39 is helpful in removing some of the ambiguities, there are still areas that are open to interpretation and where further guidance is required or standard market practice needs to evolve. Towards the end of 2004, the European Securitization Forum wrote to the International Financial Reporting Interpretations Committee (IFRIC) at the IASB seeking clarifications of how the derecognition provisions should be applied to practical securitization considerations, which IFRIC is now considering. The areas in need of clarification include:

What is meant by "substantially all" and "significant" in paragraph 20?

Under paragraph 20, an entity has retained substantially all risks and rewards of ownership if there is no significant change to the exposure to the variability in the present value of the net cashflows. An entity has transferred substantially all risks and rewards of ownership of a financial asset if its exposure to such variability is no longer significant in relation to the total variability in the present value of future net cashflows. If substantially all the risks and rewards have been transferred, the asset is derecognized, and if substantially all the risks and rewards have been retained then derecognition of the asset is precluded. Although the standard does not provide a definition of "substantially all" or "significant" or provide quantitative benchmarks or any rebuttable presumption in percentage terms, it does provide guidance in paragraphs 21 and 22, as illustrated in the appendix attached to the standard. To avoid retaining substantially all risks and rewards, some economic risk transfer from the originator to a third party is required as a minimum.

We are not advocating a hard and fast rule or even a fixed percentage to determine whether or not significant risk has been transferred, but one strong indication of risk is the pricing of the relevant tranches. In many structures, the originator holds the junior tranche of notes or provides a subordinated loan or some other type of credit enhancement so that the senior notes achieve AAA ratings.

To achieve such ratings the senior note holders are bearing almost no risk and consequently the risk is taken by the junior noteholders and derecognition is not appropriate. If, however, a third party was to provide credit enhancement in the form of an insurance wrap or a third party subscribed to the junior tranche of notes or provided a subordinated loan, the originator could claim to have transferred some risk.

IAS39: AG40 provides examples where substantially all risks and rewards are retained. Example (e) described in the guidance is the most readily relevant to securitization structures. This is a sale of trade receivables in which the entity guarantees to compensate the transferee for credit losses that are likely to occur. The standard requires that such structures fail paragraph 20(b) and require continued recognition of the asset. This view is confirmed by the Basis for Conclusion IAS 39.BC63.

The standard does not specify what statistic should be used to measure variability and does not provide an example of such a model. Until interpretation and market practice have led to a universally accepted model, there will inevitably remain a degree of uncertainty and subjectivity in the application of paragraph 20.

Should exposure assessments include hedging/risk management instruments when applying derecognition criteria?

A related question is whether or not hedging/risk management instruments used in relation to the transferred asset before the transfer should be included when assessing exposure to variability in cashflows before and after the subsequent transfer. When assessing the entities exposure before and after the transfer the incorporation or exclusion of such interest rate swaps or credit default swaps in place before transfer might have an impact on the outcome. IAS 39 requires us to consider "groups of similar financial assets" for derecognition purposes. It would appear that the hedging/risk management instrument cannot be similar to a book of assets to be securitized and so should not be included. This would appear to help the company seeking to obtain derecognition as the variability in cashflows before transfer would be increased. However it might be argued that the instrument is so unique to the underlying asset that it has no purpose apart from hedging the transferred asset.

What does transfer mean?

Financial assets might qualify for de-recognition if the originator (including the consolidated SPV) has ultimately transferred the contractual rights to receive the cashflows to the note holders. There is some uncertainty in the market as to whether this transfer needs to be a full legal assignment or whether a transfer of the beneficial entitlement to cashflows on the transferred assets would be sufficient. In practical terms, applying paragraph 18 will most certainly be viewed as an objective test as to which party owns the contractual rights to receive cashflows. In this way the party collecting the cashflows might not necessarily be the same as the one who has the benefit of those cashflows (if, for example, the originator were to retain a servicing relationship akin to an agent on an arm's length basis).

How will existing UK structures be treated under IAS 39?

In the basis for conclusions (BC63), the IASB acknowledges that many securitizations will fail the pass-through tests in paragraph 19 and fail to show that they have not retained substantially all the risks and rewards under paragraph 20b. Failure to pass these criteria will lead to continued recognition. The adoption of IAS 39 could result in continued recognition for many structures that achieve linked presentation under UK Gaap. It is unlikely that structures achieving linked presentation under FRS 5 could achieve derecognition under IAS 39. Likewise, SIC 12 might require full consolidation of the SPV. Such originators/transferors will need to examine the impacts this might have on key performance ratios, bank covenants and, for financial institutions, the regulatory treatment.

Term deals

Most UK term securitizations involve the originator retaining a substantial degree of risks and rewards inherent in the SPVs business. For example, in a typical residential mortgage-backed securities transaction, the originator will provide a subordinated loan or provide a first loss reserve. Likewise, they will also retain any excess spread emerging through a deferred consideration mechanism. This means the originator is exposed to the majority of loss risk and residual income therefore falling foul of both SIC 12 and IAS 39. In its IFRS seminar on December 14 2004, HBOS recognized that IFRS would result in stricter derecognition rules applying to their SPVs. It added that "IAS 39 will have no effect on current securitization structures or programme".

Conduits

It is possible that the sponsoring bank of a multi-seller conduit (issuing commercial paper to provide finance for trade receivable securitizations) could be required under SIC 12 to consolidate its conduit. Typically, the activities of the conduit are designed for the benefit of the sponsoring bank and any decision-making powers (for example, which assets to accept into the conduit) also lie with the sponsoring bank. There is a counter argument that it is each originator who bears the downside risk and who benefits from lower funding costs albeit that the sponsoring bank has access to an attractive fee stream.

It is clear that this sort of decision is going to be subject to the particular facts and circumstances. However some UK listed companies have already disclosed the likely impact of IAS 39 and SIC 12 in this respect. For example Barclays published an IFRS transition report in May 2005, and quantified that one of the IFRS adjustments affecting balance sheet totals compared with UK Gaap at January 1 2005 was the consolidation of conduit financing vehicles, amounting to £12 billion ($22 billion).

Revolving structures

Paragraph 19(c) appears to suggest that revolving structures, structures with reinvestment periods, controlled amortization or reserve funds automatically lead to continued recognition. It also states that the originator has an obligation to remit cashflows relating to the assets to the eventual recipients without material delay. Material delay is not defined or interpreted in the standard, leaving open the question of whether it means failure to pass cashflows on the due date set out in the contractual agreements or within a certain period after collection. While it is clear that the remittance would not need to be instantaneous, the contractual arrangements will need to be considered in full to assess whether the timeframe between collection and remittance is material.

In revolving structures, cash collections are used by the SPV to acquire new loans from the originator and replenish the portfolio to extend the life of the securitization. In such cases the collections from the assets are not being passed to the eventual recipients without material delay and not being reinvested in cash or cash equivalents so 19(c) is prima facie failed.

In many structures, the interest earned in the settlement period is retained within the SPV in a reserve fund and ultimately forms part of the residual profit returned to the originator after all contracted priority of payments defined in the legal documentation have been discharged. Accordingly, this retention of profits by the SPV could potentially give rise to material delay and cause the requirements of paragraph 19(c) to be failed.

Similarly in structures with controlled amortization, where principal collections are retained within a reserve account or are reinvested before payment to the noteholders, this retention of principal collections could give rise to material delay and give rise to problems.

Other considerations

Regulatory impact

For many years regulatory treatment of securitizations in the UK has largely been influenced by FRS 5. With the move to IFRS, the Financial Services Authority (FSA) has stated that the changes to accounting will not necessarily be reflected in the regulatory treatment.

The future regulatory treatment for bank originator/transferors will be determined by the date on which Basel II comes into effect. This date depends on national (or in the case of the UK and other European countries, EU) legislation. It introduces much more risk sensitive methods for determining banks' capital requirements for loans and other credit exposures, namely the internal ratings-based (IRB) approaches. The IRB approaches to credit risk under Basel II are expected to be available from the beginning of 2008, while the standardized approach will be available from the beginning of 2007. As a result, loans for which the capital requirements far exceed the risk will be much less common under Basel II, and the scope for using securitization to achieve regulatory arbitrage will be reduced. This conclusion is further supported by the fact that, under Basel II, a securitization has no effect for regulatory capital purposes unless it results in a transfer of economic risk, which is not usually the case at present, although this may change depending on the market response to the accounting developments. The FSA has not yet issued a policy statement on how the regulatory treatment of such transactions will be affected in the period between the introduction of IFRS with effect from January 1 2005 and the implementation of the Basel proposals.

Tax impacts

Tax can be an important issue in securitization structuring. There is a need to ensure that the structures marketed by the banks and designed with the requirements of rating agencies in mind, also suit the tax profile of the originating group and do not impose hidden costs and unnecessary rigidities for the future. IFRS could be a specific concern where the securitization SPV will be in a taxable jurisdiction where tax rules are being increasingly aligned with the accounts. One of the difficulties with IFRS is that economically broadly matching debt assets and liabilities and associated derivatives do not necessarily have matching accounting treatment. In the UK, pre-IFRS UK Gaap rules have been temporarily frozen for tax purposes in securitization vehicles while a more permanent solution is being sought. This is a focus of a great deal of lobbying and technical discussion. It is hoped that this lobbying and discussion will lead to some exclusions for SPVs used in securitization transactions.

Clearer position

As more originators with listed securities in the EU publish their IFRS transition impact reports and then their first interim reports under IFRS, market practice will become more established. The impact of the convergence of UK Gaap to IFRS will also need to be contemplated by non-listed issuers. The flux in the potential regulatory and tax impact only adds to the uncertainty. The position is becoming clearer but there is still some way to go.

Author biographies

David Barnes Deloitte & Touche LLP David Barnes is a partner, the head of securitization in the UK at Deloitte and a member of the global securitization team. David has been involved in the securitization industry since the late 1980s and has advised a range of banks and issues on accounting, regulatory, due diligence and feasibility issues. David is an active member of the European Securitization Forum accounting sub-committee. Simon Stephens Deloitte & Touche LLP Simon Stephens is a senior manager both in the UK and global securitization team at Deloitte. Simon has specialized in securitization since 2000, providing accounting, advisory and due diligence services to clients.